Risk Effects Versus Monetary Effects in the Determination of Short-term Interest Rates
Economic theory offers two distinct approaches to the modelling of interest rates. At the microeconomic level, interest rates are modelled as an outcome of intertemporal optimisation by investors, so that real interest rates are determined entirely by the real variables that characterise risk. At the macroeconomic level, short term behaviour of interest rates is usually thought of as being governed by the money demand function. This paper tests a model that encompasses both views, using data for four countries. The results suggest that risk factors are empirically insignificant in explaining interest rate behaviour.
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