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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-à-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. Vincent Koen, 1991. "Testing the Credibility of the Belgian Hard Currency Policy," IMF Working Papers 91/79, International Monetary Fund.
    2. John Williamson, 1994. "Estimating Equilibrium Exchange Rates," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 17.
    3. Leonardo Bartolini, 1993. "Devaluation and Competitiveness in a Small Open Economy; Ireland 1987-1993," IMF Working Papers 93/82, International Monetary Fund.
    4. Steven A. Symansky & Peter B. Clark & Leonardo Bartolini & Tamim Bayoumi, 1994. "Exchange Rates and Economic Fundamentals; A Framework for Analysis," IMF Occasional Papers 115, International Monetary Fund.
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    Cited by:

    1. 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, pages 409-431, November.

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