Interest Rate Linkages within the European Monetary System: A Time Series Analysis 授课教授：杨奕农 学 生：文仲琴

CONTENTS 1. introduction 2. methological issues 3. empirical results 4. conclusions

1. INTRODUCTION The objective behind the foundation of the European Monetary System (EMS) in March 1979 was the creation of a system of monetary stability in Europe.

The higher exchange rate stability observed during the EMS period was combined with a reduction in, but not the elimination of, the response of the German mark (DM) cross rates to changes in the effective dollar rate. Taylor and Artis (1988) found evidence of nonzero risk premia between DM and the other EMS currencies, but could not reject the zero risk premium hypothesis between dollar and DM.

The paper addresses the issue of interest rate linkages between Germany and the other EMS countries. 1. Investigates whether there exist long-run comovements between German and other EMS members' rates by employing integration and cointegration techniques. 2. Examines whether German interest rate changes convey information about future movements of other EMS interest rates.

2. METHODOLOGICAL ISSUES In a two-country context with highly substitutable assets, international portfolio equilibrium is specified as: 𝑖 𝑡 - 𝑖 𝑡 ∗ = 𝐸 𝑡 𝑠 𝑡+1 - 𝑠 𝑡 + 𝑣 𝑡 (1) i and i* denote domestic and foreign interest rates, respectively. Et refers to expectations at time t, s is the logarithm of the exchange rate, v represents the risk premium.

𝑖 𝑡 -b 𝑖 𝑡 ∗ = 𝜔 𝑡 (2) in contrast to (1), b is allowed to deviate from unity and the right- hand side of (1) is suppressed into 𝜔 𝑡 . The reason for allowing b # 1 can be clarified by considering interest income taxation and/or the possibility of measurement errors.

The lack of a hatmonized tax system within the EMS and the existence of interest income taxation modifies the interest parity condition to 𝑖 𝑡 （1-τ）- 𝑖 𝑡 ∗ （1- 𝜏 ∗ ）= 𝑧 𝑡 (3) τ and 𝜏 ∗ are the rates at which interest income is taxed. Equation (3) is equivalent to (2) with b=（1- 𝜏 ∗ ）/（1-τ）and 𝜔 𝑡 = 𝑧 𝑡 /（1-τ）. Clearly if τ≠ 𝜏 ∗ ，then b≠1.

𝑖 𝑡 =β+γ 𝑟 𝑡 + 𝑢 𝑡 （4） 𝑖 𝑡 ∗ = 𝛽 ∗ + 𝛾 ∗ 𝑟 𝑡 ∗ + 𝑢 𝑡 ∗ （5） β，γ， 𝛽 ∗ and 𝛾 ∗ capture systematic measurement errors and 𝑢 𝑡 and 𝑢 𝑡 ∗ are stationary random errors. Substituting for 𝑟 𝑡 and 𝑟 𝑡 ∗ into (1), we end up with (2), where b=γ 𝛾 ∗−1 , and 𝜔 𝑡 =γ（ 𝐸 𝑡 𝑠 𝑡+1 - 𝑠 𝑡 + 𝑣 𝑡 ） + 𝑢 𝑡 −γ 𝛾 ∗−1 𝑢 𝑡 ∗ .

3. EMPIRICAL RESULTS Table 1 unit root tests for short-term domestic interest rates

Table 2 tests of cointegration between German and other EMS interest rates

Table 3 causality tests of unrestricted and restricted VAR systems

Table 4 correlation coefficients of innovations in VAR systems

4. CONCLUSIONS This paper has concentrated on the bivariate analysis of interest rate linkages within the EMS. Cointegration tests have not revealed the existence of systematic interest rate relationships in the long run between Germany and any of the other EMS countries.

Bivariate vector autoregression analysis has been used to investigate the information content of German interest rates about the future course of other members' rates. the evidence of unidirectional interest rate linkages from Germany to other EMS countries, regardless of the nature and degree of restrictions on capital movements.

Thank You