Analysis of the Goods Market and Money Market Equilibrium in a Developing Country

Abstract

The relationship between interest rate, real money balances and real output may be explored in an IS-LM framework. The objective of this study is to explore the connection between real interest rate, GDP and real money balances. It also empirically tests for the nature and existence of the IS-LM framework in Ghana. Employing a simple IS-LM framework, the Two Stage Least Squares (TSLS) estimation technique is used for the analysis. The main contribution of this paper is the use of a simultaneous equation framework to investigate interest rate and GDP growth determinants. This is imperative since interest rate is both an explanatory and an explained variable. The results indicated that real money balances exerted a negative but significant influence on real interest rate. The growth rate of GDP had a dominant influence on real interest rate. On the other hand, investment expenditure exerted significant and positive influence on GDP growth. Meanwhile, as informed by economic theory, interest rate changes had a negative and significant influence on GDP growth. The study recommends the role of monetary policy and economic growth in exchange rate management. Also, policy focus should be on interest rate since interest rate is seen in this study as a stronger driver of economic growth in Ghana compared with investment expenditure.