1. The Euro Area and World Interest Rates Menzie D. Chinn Univ. of Wisconsin-Madison & NBER Jeffrey A. Frankel Harvard University & NBER Presentation at Elteville, Germany September 13, 2003

2. Motivation Revisit the determinants of interest rates Investigate the impact of EMU Re-examine the role of debt against backdrop of new theory & empirics

3. The Shift in Fiscal Conditions: Budget Surplus Source: OECD Economic Outlook, June 2003

4. The Shift in Fiscal Conditions: Net Debt Source: OECD Economic Outlook, June 2003

5. Is There a Debate? “studies that (properly) incorporate deficit expectations in addition to current deficits tend to find economically and statistically significant connections between anticipated deficits and current long-term interest rates.” (Gale and Orszag, 2003, p. 20)

6. Quantitative vs. Qualitative The small effect of debt on interest rates does show... that attempts to stimulate the economy by raising taxes in order to lower interest rates are likely to be unsuccessful... The resulting reduction in interest rates will probably be too small to outweigh the negative effects of tax increases … (ERP 2003, p.58)

7. Findings Short term rates tightly linked Long term rates have country-specific effects US rates still matter for European rates Debt matters

8. Outline Short term nominal rate dynamics Long term real rate dynamics Determinants of long term real rates Conclusions and Outlook

9. Convergence at the Short Horizon? Source: IFS, June 2003

10. Real Rate Convergence? Source: IFS, June 2003 and author’s calculations

11. European Convergence Source: IFS, June 2003

12. US and Euro Area Policy Rates Source: IFS, June 2003

13. Who Drives Rates? Source: IFS, June 2003

14. Testing for Convergence

15. Results Table 1: Nom. Money mkt. rates

16. Longer Horizons Less linkage expected (liquidity issues, political risk) Evolution over time (dismantling of capital controls) Empirical literature

17. Convergence in Long Term Rates Source: BIS, July 2003

18. US, Germany, France Source: BIS, July 2003, and author’s calculations

19. US, Italy, Spain Source: BIS, July 2003, and author’s calculations

20. Estimation

21. Results: 1973-95 Table 2: Long term real rates

22. Results: 1996-2003 Table 2: Long term real rates

23. Panel Results Table 3: Long term real rates

24. Determinants of Real Interest Rates 1988-2002 Annual data Debt, expected debt Cyclical factors Foreign factors (interest rate, global debt)

25. Estimation

26. Results Table 5: Determinants of long term real rates

27. Panel Results Table 6: Determinants of European long term real rates

28. Interpretation Debt matters Expected debt sometimes matters Output gap not consistently important US interest rates matter for European countries Global debt doesn’t enter as expected

29. Conclusions US interest rates still appear to drive other interest rates, but less so Idiosyncratic country effects remained important Unclear for post-EMU period Likely that debt trends will matter in coming years

30. Implications Source: OECD, BIS and author’s calculations