Journal of Economics and Sustainable Development www.iiste.org ISSN 2222-1700 (Paper) ISSN 2222-2855 (Online) Vol.4, No.10, 2013 44 The Impact of Interest Rates on the Development of an Emerging Market: Empirical Evidence of Nigeria. Obadeyi James Ayanwale Department of Accounting and Finance, Faculty of Humanities and Management Sciences, Elizade University, P.M.B 002, Ilara- Mokin, Ondo State, Nigeria. Tel: +23408033569575 Email: james.obadeyi@elizadeuniversity.edu.ng Acknowledgement I will like to appreciate Central Bank of Nigeria (CBN) for the data used in the study. Also Dr. Akingunola Richard of the department of Accounting and Finance, Olabisi Onabanjo University, Ago-iwoye for his helpful advice and Mr. Afolabi Kehinde Victor of Banking Supervision Department, CBN, Lagos, for his financial support. Abstract The study reveals that interest rate is always difficult to forecast. Interest rates will probably rise with the removal of public sector funds from the industry. The interest rate (MPR) is the rate at which banks borrow from Central Bank to cover their immediate cash shortfall. The higher the cost of such borrowing, the higher also will be the rate banks will advance credit to the real sector. However, in the long-term, with re-capitalization on banks, insurance companies’ e.g. could begin to exploit economies of scale to compete on pricing and improve their deposit mobilization capabilities, which could positively affect interest rates. The Central Bank of Nigeria (CBN) has not formulated a model that will reduce interest rate, inflation and stabilize the exchange rate. However, a time series analysis was adopted for 40 years (1970- 2010).The Error Correction Modelling (ECM) was adopted to reconcile fluctuations or changes both in the short and long run between the variables. The result shows that due to the ability to estimates the parameters of Error Correction Mechanism (ECM), which is generally consistent, sufficient, significant and negative. The non-zero coefficient of ∆INT t and INF t in both ways, if statistically significant, will indicate a short-run causality from ∆INT t to ∆Gcf t as well as ∆INF t to ∆GDP t . The paper recommends that pragmatic approach needs to be adopted to ensure that the lending rates are reduced to single digit in order to reduce production cost, high unemployment rate and encourage Foreign Direct Investment (FDI). The monetary policy rate (MPR) at 12% (CBN, 2013) is too high for a developing economy such as Nigeria because it will have a negative impact on the naira exchange rate. Monetary and fiscal policies remain necessary and sufficient conditions for attaining a realistic interest rate performance. Interest rate management in a depressionary economy needs regular fine-tuning of relevant instruments by the monetary authorities. Keywords: Interest rate, Capital formation, Inflation, Monetary and fiscal policy, Central bank. 1. Introduction The financial systems of most developing nations have come under stress as a result of the economic shocks of the 1980s and early in 2008 in Nigeria. Financial repression shows through indiscriminate distortions of financial prices to reduce the real rate of growth and size of the financial sector to non-financial magnitudes. It is obvious in recent times, that financial repression has retarded the development process as envisaged by (Shaw, 1973; Ephraim, 2001). Undoubtedly, governments’ past efforts to promote economic development by controlling interest rates and securing “inexperience” funding for their own activities have undermined financial development. Capital formation can lead to increase in size of national output, income and employment thereby solving the problems of inflation and balance of payment and making the economy free from the burden of foreign debts (Agagi 1990). The strains on inflationary pressure on a developing economy can be removed to a considerable extent by increased capital formation, in the long-run, it augments the supply of goods, control inflation and brings stability in the economy (Khoury 1983). Capital is always formed when some resources available in the current period are devoted to the creation of intermediate goods (which can be used for further production) or to the pilling-up of inventories of final goods which are not intended to be consumed during the current period. The essence of capital formation is a postponement of consumption. Consequently, most countries, both developed and developing have taken steps to liberalize their interest rates as part of the reform of the entire financial system (banks and non- banks) as witnessed in 2008 and recently in 2011 in Nigeria. Such liberalization represents a policy response, encompassing a package of measures to remove all undesirable state imposed constraints on the free working of the financial markets. (Killick & Martin, 1990). The reform in the financial market and banks remain a consistent force for the development of less developed economies (Kent & John,