The Nexus between interest rates and inflation in South Asia: the role of risk premiums and economic growth

Inflation remains a persistent challenge for South Asian economies, significantly impacting economic stability and growth. This study, covering the period from 1995 to 2023, aims to examine the effects of key economic variables—deposit and lending interest rates, risk premiums on lending, and economic growth—on inflation dynamics in six South Asian countries: Bangladesh, Bhutan, India, Maldives, Pakistan, and Sri Lanka. The research employs a robust econometric approach, including descriptive statistics, correlation analysis, Unit Root Tests, Cointegration tests, and multiple regression models such as OLS, Fixed Effects (FE), Random Effects (RE), and IV-GMM. Furthermore, quantile regression and Bayesian Random-Effects models are utilized to account for non-linearities and uncertainties in the inflationary process. The study finds that both deposit and lending interest rates significantly influence inflation, with varying effects across the countries. Risk premiums on lending and GDP growth also contribute to inflation dynamics, though their impacts differ depending on each country's economic context. The results highlight that inflation in South Asia is driven by a combination of domestic policies, external shocks, and structural economic challenges, underscoring the need for tailored inflation management strategies. Given the region's diverse economic environments, the study emphasizes the importance of adopting country-specific approaches to address inflation effectively. Ultimately, the research provides valuable insights for policymakers seeking to design more effective, region-specific strategies to control inflation and promote sustainable economic growth in South Asia.