The fundamental determinants of interest rate differentials in the ERM

Klass H. W. Knot

Applied Economics, 1998, vol. 30, issue 2, 165-176

Abstract: The paper analyses the sources of persistent interest rate differentials vis-�-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.

Date: 1998
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DOI: 10.1080/000368498325976

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