Real interest rates and growth: Improving on some deflating experiences

Tests of the McKinnon‐Shaw hypothesis typically investigate the relationship between real interest rates and growth. Recent work has concluded that this relationship may be non‐monotonic. This article investigates the role of real interest rate mismeasurement in explaining these non‐monotonicities. When such mismeasurement is systematically related to growth, it will produced biased empirical results. After addressing these biases, the article demonstrates that financial liberalisation may offer substantial economic gains. In an ‘average’ country, raising real interest rates from ‐25 per cent to five per cent will increase real annual per capita GDP growth from zero to a relatively robust rate of two per cent.