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The fundamental determinants of interest rate differentials in the ERM

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  • Klass H. W. Knot

Abstract

The paper analyses the sources of persistent interest rate differentials vis-�-vis Germany that have existed in Belgium, Denmark, France, Ireland, Italy, and the Netherlands. In a target zone system like the ERM, interest rate differentials mainly reflect devaluation expectations, which are measured here by raw 1-month Euromarket interest rate differentials, drift-adjusted 1-month differentials, and differentials in long-term government bond yields. The role of a large set of fundamental macroeconomic variables that may have affected these devaluation expectations is investigated within a vector autoregressive (VAR) setting, by means of Granger-causality tests, impulse-response functions and variance decompositions. We find no evidence that fundamentals are more relevant to drift-adjusted devaluation risk than for unadjusted interest rate differentials. A significant impact of inflation, budget deficits, and unemployment becomes evident for almost all ERM-participants.

Suggested Citation

  • Klass H. W. Knot, 1998. "The fundamental determinants of interest rate differentials in the ERM," Applied Economics, Taylor & Francis Journals, vol. 30(2), pages 165-176, February.
    • Handle: RePEc:taf:applec:v:30:y:1998:i:2:p:165-176
    DOI: 10.1080/000368498325976
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    References listed on IDEAS

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    1. Klaas H.W. Knot, 1996. "Fiscal Policy and Interest Rates in the European Union," Books, Edward Elgar Publishing, number 1086.
    2. Mr. Leonardo Bartolini, 1993. "Devaluation and Competitiveness in a Small Open Economy: Ireland 1987-1993," IMF Working Papers 1993/082, International Monetary Fund.
    3. Mr. Vincent Koen, 1991. "Testing the Credibility of the Belgian Hard Currency Policy," IMF Working Papers 1991/079, International Monetary Fund.
    4. William Ellery Channing, 1994. "Change," American Journal of Economics and Sociology, Wiley Blackwell, vol. 53(1), pages 15-15, January.
    5. John Williamson, 1994. "Estimating Equilibrium Exchange Rates," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 17, April.
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    Cited by:

    1. Carlos Vieira, 2004. "The Deficit?Interest Rate Connection: an empirical assessment of the EU," Economics Working Papers 5_2004, University of Évora, Department of Economics (Portugal).
    2. Peter Tillmann, 2003. "The Regime‐Dependent Determination of Credibility: A New Look at European Interest Rate Differentials," German Economic Review, Verein für Socialpolitik, vol. 4(4), pages 409-431, November.
    3. Frömmel, Michael & Kruse, Robinson, 2015. "Interest rate convergence in the EMS prior to European Monetary Union," Journal of Policy Modeling, Elsevier, vol. 37(6), pages 990-1004.
    4. Francesco Macheda, 2018. "The illusion of patient capital: evidence from pension investment policy in the Netherlands," Working Papers 0029, ASTRIL - Associazione Studi e Ricerche Interdisciplinari sul Lavoro.

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