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The convergence of international interest rates prior to Monetary Union

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  • Wilfling, Bernd

Abstract

The process of international interest rate convergence for arbitrary terms (represented by the term structure of interest rate differentials) is derived in a model of a small open economy which faces a purely time-contingent exchange rate regime switch from flexible to fixed rates. Special attention is paid to a situation in which financial markets deem a delay in the regime switch beyond the publicly announced fixing date possible. The closed-form solution of the term structure allows us to analyze the volatility of interest rate differentials thus providing a useful tool for interest-rate-sensitive security valuation and other risk management applications. Furthermore, the model demonstrates that the economy under consideration has to pay for the exchange rate stabilization triggered by the mere announcement of future regime switching by a higher uncertainty in the evolution of domestic interest rates.

Suggested Citation

  • Wilfling, Bernd, 2001. "The convergence of international interest rates prior to Monetary Union," HWWA Discussion Papers 127, Hamburg Institute of International Economics (HWWA).
  • Handle: RePEc:zbw:hwwadp:26165
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    Keywords

    Exchange rate regime switches; interest rates; term structure; stochastic processes; uncertainty;

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F31 - International Economics - - International Finance - - - Foreign Exchange

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