Looking for Contagion: the Evidence from the ERM
This paper applies a full-information technique to test for the presence of contagion across the money markets of ERM members. We show that whenever it is possible to estimate a model for interdependence, a test for contagion based o a full information technique is more powerful. We test for the presence of contagion after having identified episodes of country-specific shocks, whose effect on other European markets is significantly different from those predictable from the estimated channels of interdependence. Using data on three-month interest rate spreads on German rates for seven countries over the period 1988–1992, we are unable to reject the null of contagion. Our evidence suggests that contagion within the ERM was a general phenomenon not limited to a subset of weaker countries, the exception in our sample being France. Our result are mute as to the question of what lies behind these episodes of contagion; they show, however, that it is not always that one only detects contagion when one applies poor statistical techniques.
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