The Impact of Interest Rate on Investment in Jordan: A Cointegration Analysis

The main aim of this study is to investigate the impact of real interest rate on investment level in Jordan over the period (19902005). A cointegration analysis with three variables (investment level, real interest rate, and income level) is employed. Two unit root tests (Phillips-Perron test and Augmented DickeyFuller test) have been exploited to check the integration order of the variables. The Johansen Cointegration test is mainly used. And for the purpose of supporting the results, the dynamic relationships among the variables are explained through presenting variance decomposition and impulse responses. The results were found to be in line with the economic theory and some other studies in the sense that real interest rate has a negative impact on investment, where it is found that an increase in the real interest rate by 1% reduces the investment level by 44%. On the other hand, the income level has a positive impact. Introduction Investment is considered to be an important factor in economic growth (AlTarawneh, 2004). So, economists and policy makers have been interested in studying the major determinants of the investment level. One of the prospective determinants is the real interest rate. In the Jordanian economy, during the 1970s and 1980s, the interest rate was completely determined by the Central Bank of Jordan. Since the beginning of Ahmad Ibrahim Malawi and Majed Bader 200 the 1990s, interest rates have become almost floated and commercial banks are competing with each other in determining the level of interest rate. Objective of the Study This study aims at investigating the impact of the real interest rate on the investment level in Jordan over the 1990-2005 period. The central hypothesis of this study is that the real interest rate has a negative impact on the investment level. Economic Literature and Previous Studies There are two conflicting views of the effect of the real interest rate on the level of private investment. A high interest rate level raises the real cost of capital and therefore dampens the private investment level. On the other side, poorly developed financial markets in less developing countries (LDCs) and inadequate access to foreign financing for most private projects, both imply that private investment is constrained largely by domestic savings. These, in theory, are expected to respond positively to higher real interest rates. For this reason, private investment could, on balance, be positively related to interest rates in developing countries (Greene and Villanueva, 1990). As for previous empirical studies, because of the huge number of these studies, five of them were chosen. The first study is conducted by Greene and Villanueva (1990). They explored the determinants of private investment in less developing countries for 23 countries over the 1975-1987 period, and found that the real deposit interest rate has a negative impact on private investment. The second study by Hyder and Ahmad (2003) was about the slowdown in private investment in Pakistan. They found that higher real interest rates reduce private investment. Larsen (2004), in the third study about the United States, has found that low mortgage interest rates make direct real estate investments attractive to suppliers of the real estate units. Aysan and others (2005), in the fourth study, analyzed the determinants of unsatisfying private investment growth in the Middle East and North Africa (MENA) throughout the 1980s and 1990s. Their findings have shown that the real interest rate appears to exert a negative effect on a firm investment projects. And in the last study, Wang and Yu (2007) examined the role of interest rate in investment decisions for firms in Taiwan. Their results reveal that the interest rate plays an important role in investment decisions.