Abstract
The classical theory of interest rate determination is examined within the framework of India’s post-liberalization economy from 1991 to 2021. Using an Autoregressive Distributed Lag (ARDL) framework, it explores both the long-run and short-run dynamics between deposit rates and savings, as well as lending rates and investment. The analysis highlights three critical breakpoints—in 1995, 2004, and 2013—that required the incorporation of break dummies and interaction terms to maintain model stability and validity. The results reveal a significant positive relationship between deposit rates and savings, and a significant negative relationship between lending rates and investment. These findings provide empirical support for the classical theory of interest rate determination. The results further indicate that the influence of interest rates on savings and investment became more pronounced in the post-liberalization period, reflecting a shift toward greater reliance on market-driven mechanisms within the financial system. Moreover, the robustness of these outcomes is confirmed by consistent results from diagnostic and stability tests, which establish the reliability and validity of the estimated models. However, further assessment of how closely these findings align with the actual movement of interest rates in India in recent years could help to evaluate the practical relevance of the classical theory and enhance the understanding of interest rate dynamics, thereby supporting the design of more effective monetary policies.
Keywords: ARDL, Classical Theory of Interest Rate, Post-Liberalization, Structural Breaks.