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EMS interest rate differentials and fiscal policy: a model with an empirical application to Italy

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  • R. Sean Craig

Abstract

This paper develops a model showing how EMS interest rate differentials are influenced by fiscal policy. For countries like Italy, with large budget deficits, the commitment to a stable EMS exchange rate can entail costly fiscal adjustment. If the government believes these costs to be excessive, it may choose to adopt a more inflationary monetary policy and realign periodically. It is this possibility that the policy of targeting the stable exchange rate will be abandoned in favor of one with periodic EMS realignments that contributes to the interest differential. ; Estimation of the model indicates that fiscal variables explain part of the Italian-German interest differential, and co-integration tests reveal that this relationship holds over the long-run. These results imply that the Italian-German interest differential is likely to persist in the second stage of European Monetary Union (EMU) if Italy fails to reduce its budget deficit, providing support for the view that fiscal convergence is a necessary element of EMU.

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  • R. Sean Craig, 1991. "EMS interest rate differentials and fiscal policy: a model with an empirical application to Italy," International Finance Discussion Papers 405, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:405
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    References listed on IDEAS

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    1. Giuseppe Bertola & Lars E. O. Svensson, 1993. "Stochastic Devaluation Risk and the Empirical Fit of Target-Zone Models," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 60(3), pages 689-712.
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    3. Luigi Spaventa, 1987. "The Growth of Public Debt: Sustainability, Fiscal Rules, and Monetary Rules," IMF Staff Papers, Palgrave Macmillan, vol. 34(2), pages 374-399, June.
    4. Svensson, Lars E. O., 1991. "The term structure of interest rate differentials in a target zone : Theory and Swedish data," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 87-116, August.
    5. Buiter, Willem H., 1987. "Borrowing to defend the exchange rate and the timing and magnitude of speculative attacks," Journal of International Economics, Elsevier, vol. 23(3-4), pages 221-239, November.
    6. Rose, Andrew K & Svensson, Lars E O, 1991. "Expected and Predicted Realignments: The FF/DM Exchange Rate During the EMS," CEPR Discussion Papers 552, C.E.P.R. Discussion Papers.
    7. Poterba, James M & Rotemberg, Julio J, 1990. "Inflation and Taxation with Optimizing Governments," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 22(1), pages 1-18, February.
    8. Brian Griffiths & Geoffrey E. Wood, 1984. "Monetarism in the United Kingdom," Palgrave Macmillan Books, in: Brian Griffiths & Geoffrey E. Wood (ed.), Monetarism in the United Kingdom, pages 3-12, Palgrave Macmillan.
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    Cited by:

    1. R. Sean Craig, 1994. "Who will join EMU? Impact of the Maastricht convergence criteria on economic policy choice and performance," International Finance Discussion Papers 480, Board of Governors of the Federal Reserve System (U.S.).
    2. Hafer, R. W. & Kutan, Ali M. & Su Zhou, 1997. "Linkage in EMS term structures: evidence from common trend and transitory components," Journal of International Money and Finance, Elsevier, vol. 16(4), pages 595-607, August.

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