The liberalization of interest rates has triggered the interest of researchers in India to examine if interest rates are market determined and develop robust models to account for the relationship of macroeconomic variables with interest rates. This paper attempts to examine the relationship between macroeconomic variables and short-term interest rates using Hierarchical RegressionOrdinary least squares method. The results show that yield spread, monetary policy change and forward premia play an important role in the determination of domestic interest rates.

Short-term interest rates are influenced by the changes in monetary policy, liquidity, demand and supply of credit, level of inflation, global interest rates and the level of economic activity. In the Indian context, this relationship was not given much focus until the beginning of 1990s due to the administered interest rate mechanism. Since the beginning of economic reforms and the liberalization of capital market, the interest rates were allowed to float, except the Bank Rate and the interest rate on savings deposits and the question of determining the interest rates became a big issue. The interest rate is a key financial variable that affects decisions of consumers, businesses, financial institutions, professional investors and policymakers. Movements in interest rates have important implications for the economy's business cycle and are crucial to understanding financial developments and changes in economic policy. Timely forecasts of interest rates can therefore provide valuable information to financial market participants and policymakers. Forecasts of interest rates can also help to reduce interest rate risk faced by individuals and firms. Forecasting interest rates is also very useful to central banks in assessing the overall impact (including feedback and expectation effects) of its policy changes and taking appropriate corrective action, if necessary. In fact, the usefulness of the information contained in interest rates greatly increases particularly with financial sector liberalization.

Steps to liberalize interest rates started in the late 1980s. Certificate of deposits were introduced in June 1989 and commercial paper in January 1990. However, the reforms did not gain momentum until mid-1992 when rates of interest in India were gradually decontrolled in a variety of ways. The most important interest rates are now market determined. In mid-1992, the Reserve Bank of India also introduced new government securities through auction sale. These included 364-day Treasury bills, and five-year and ten-year bonds. The year 1993 also marked the beginning of the era of a freely floating exchange rate system. From 1975 to 1992, the rupee exchange rate was officially determined by the Reserve Bank of India and was based on a weighted basket of currencies of India's major trading partners.

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