Mauritian financial system has been through a long phase of financial reforms since the mid-1980s with interest rate liberalization as a major objective. The financial market, like the goods market can achieve equilibrium where demand for funds equals the supply of funds. There is evidence of increased flexibility in interest rates during the post-liberalization period as compared to the period when interest rates were regulated by monetary authorities.Interest rate liberalization strategy in developing countries is based on the premise that, interest rates set below their market clearing levels, result in misallocation of financial resources and adversely affect investment and economic growth (McKinnon, 1973; Shaw, 1973; Fry, 1995). The behavior of interest rates in the aftermath of liberalization in many developing countries has spurred considerable research over the preceding decades (McKinnon 1991, Turtelboom 1992).

A number of issues have been investigated such as the asymmetric adjustments in interest rates, impact of banking market structure, financial market imperfections, banking supervision, capital account liberalization and macro economic conditions on the behavior of interest rates in a liberalized regime. The unexpected hike in real interest rates in the aftermath of liberalization in the south cone of Latin America, has been well documented in the literature leading to important policy implications relating to the approach of liberalization (World Bank 1989, Fry 1995, Mckinnon 1991).

Likewise many developing countries, the Mauritian financial system has been through a long phase of financial reforms since the mid-1980s, with interest rate liberalization as a major objective (Bundoo and Dabee 1999, Junglee 1999, World Bank 2003). It will be instructive to assess the impact of the financial reforms on interest rate flexibility. Using a money market model with partial adjustment mechanism in line with Lee et al., (1998), an investigation of interest rate behavior is undertaken. After highlighting the main financial reforms in Section 2, we discuss the financial market model and the sources of data in Section 3. Then, the estimated results are presented and analyzed in Section 4. Section 5, concludes the paper and highlights the main policy implications.