IDEAS home Printed from https://ideas.repec.org/a/euf/qreuro/0144-03.html
   My bibliography  Save this article

Revisiting the real interest rate mechanism

Author

Listed:
  • Eric Ruscher
  • Borek Vasicek

Abstract

The pro-cyclical effect of real interest rates is a well-known impediment to market-based adjustment to asymmetric shocks in a monetary union. This real interest rate mechanism has been at work in the euro area since its inception, partially offsetting the stabilising effect of the relative price mechanism discussed in the previous chapter. Member States with stronger cyclical positions than the rest of the euro area have experienced comparatively higher inflation rates and as a result lower real interest rates. These real interest rate differences have tended to reinforce cyclical differences via the investment channel. Before the global financial crisis, nominal interest rates were converging as a result of financial integration, while persistent inflation differentials were the main cause of significant Member State differences in real interest rates. Since the crisis, real rate differentials have been magnified by a rise in nominal interest rate dispersion due to financial fragmentation. This has added a nominal component to the traditional real interest rate mechanism. Given the dominant role of bank loans in financing the euro area economy, this chapter assesses the importance of this new nominal component by looking at the drivers of lending rates for households and non-financial corporations. Econometric analysis shows that the divergence in bank lending rates since the global financial crisis can be explained not only by the perceived redenomination risks at the height of the euro area debt crisis but also by country-specific factors, including divergences in sovereign spreads, in domestic activity and in the quality of bank balance sheets. The identified effects of sovereign spreads and bank balance sheets on lending rates should be mitigated by past or ongoing policy and governance changes in EMU. However, the link between lending rates and domestic activity is likely to persist. Therefore, the nominal magnifier of the traditional real interest rate mechanism should not be seen as a temporary effect of the euro area debt crisis but rather as an integral part of adjustment in EMU although its magnitude is expected to be lower in the future in the absence of perceived redenomination risk.

Suggested Citation

  • Eric Ruscher & Borek Vasicek, 2016. "Revisiting the real interest rate mechanism," Quarterly Report on the Euro Area (QREA), Directorate General Economic and Financial Affairs (DG ECFIN), European Commission, vol. 14(4), pages 33-48, January.
  • Handle: RePEc:euf:qreuro:0144-03
    as

    Download full text from publisher

    File URL: https://ec.europa.eu/info/sites/info/files/ip016_en_3.pdf
    Download Restriction: no

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:euf:qreuro:0144-03. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (ECFIN INFO). General contact details of provider: http://edirc.repec.org/data/dg2ecbe.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    We have no references for this item. You can help adding them by using this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.