Interest Rate Determination-An Error Correction Model

Integration of the domestic market for funds with foreign money markets is a natural corollary of financial sector liberalisation. For a transition economy like India, therefore, we assume interest rates to be a combination of an autarkic rate as in a closed economy and the uncovered interest parity rate as in a completely open economy. Wecapture both the long run and the short run dynamics of domestic interest rate behaviour by estimating an error correction model using the Engle-Granger methodology. Econometric analysis suggests that as the Indian financial sector integrates more and more withglobal markets, returns on foreign assets playa significant and increasing role in the determination of domestic interest rates.