Asymmetry in the ERM
A Case Study of French and German Interest Rates Since Basle-Nyborg
Author: Mr. W. R. M. Perraudin1 and Mr. E. H. Gardner
  • 1 0000000404811396https://isni.org/isni/0000000404811396International Monetary Fund
Publication Date:
01 Nov 1992
eISBN:
9781451949988
Language:
English
Keywords:
WP; deutsche mark; monetary policy; descriptive statistics; interest rate level
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We study empirically daily French and German interest rate changes since the Basle-Nyborg agreement of September 1987. In particular, we ask whether the shock associated with German unification altered the degree of leadership of German monetary policy in the ERM. We conclude that Germany’s leadership role within the ERM largely disappeared in the year following unification but that the Bundesbank has recently begun to reassert its predominance.

Abstract

We study empirically daily French and German interest rate changes since the Basle-Nyborg agreement of September 1987. In particular, we ask whether the shock associated with German unification altered the degree of leadership of German monetary policy in the ERM. We conclude that Germany’s leadership role within the ERM largely disappeared in the year following unification but that the Bundesbank has recently begun to reassert its predominance.

I. Introduction

This paper analyzes the leader-follower relationships between different countries’ interest rates within the ERM. Our study is particularly timely given the recent European currency crisis that has seen sterling and the lira suspended as full members of the ERM. Some have suggested that the crisis is the product of German insensitivity to economic developments in, and the policy requirements of, other ERM members. Others have argued that the ERM is predicated upon German monetary leadership and that it is unrealistic to expect credibility gains from adherence to a target zone system unless the leader country is allowed to adopt anti-inflationary policies appropriate to its own domestic situation. By examining high frequency interest rate data, we aim to shed light on what has actually happened over the last five years, focussing especially on the way in which Germany’s role was affected by reactions to German unification. Our main conclusion is that, in the year following unification, Germany largely lost its leadership role within the ERM. Since then, however, Germany has increasingly reasserted its predominance.

Various authors have characterized the ERM as a currency block dominated by German monetary policy. Giavazzi and Giovannini (1987, 1988) argued that the ERM evolved from the cooperative system originally intended into one centered on the deutsche mark (DM) because of the desire of countries with poor inflation records to profit from the credibility of German monetary policy. An alternative explanation for the perceived asymmetry in the functioning of the ERM was proposed by Wyplosz (1989a), who explains the leadership role of Germany in terms of an inherent bias rather than the outcome of self-imposed constraints by ERM member countries. In his model, any fixed exchange rate regime produces this sort of bias, essentially because the country with the more restrictive monetary stance, i.e., the country accumulating reserves, has a greater capacity for sterilized intervention than the country losing reserves. Russo and Tullio (1988), and Ungerer et al., (1990) make similar arguments, suggesting that the rules of the ERM confer a central role on German policy since reserve losses caused by interventions within the band have generally obliged the weaker currency country to adjust more than the strong currency country.

The view that German monetary policy dominates the ERM has found surprisingly little support in the empirical literature, however. Most empirical studies suggest that Germany is an important player in the ERM., but that German monetary policy is also affected by innovations in other ERM member countries. For example, Cohen and Wyplosz (1989) and De Grauwe (1989) tested the hypothesis of German leadership through simple Granger causality tests applied to changes in national interest rates and monetary aggregates in ERM countries.

Both studies concluded that the asymmetry in the ERM was much weaker than generally thought, although De Grauwe also found strong evidence of German leadership in off-shore markets, based on the response of Euromarket interest rates to changes in the forward premium vis-a-vis Germany. However, as Weber (1990) and De Grauwe (1989) pointed out, Granger causality tests are of limited significance when policy response is rapid, since they fail to capture contemporaneous “causality” effects. Moreover, Weber noted that causality tests applied to monetary aggregates are likely to be distorted by the effect of sterilization of foreign exchange interventions: any EMS country that intervenes using deutsche marks to support its own currency might appear to “cause” changes in German monetary aggregates simply because of the time it takes for Germany to sterilize.

An alternative way to analyze the joint behavior of innovations in interest rates and monetary aggregates in the ERM, that does not suffer from the problems with Granger causality tests mentioned above, consists of estimating systems of equations in which contemporaneous linkages between interest rates are identified on the basis of an underlying structural model, more or less explicitly derived from a central bank reaction function. Fratianni and von Hagen (1990) and von Hagen and Fratianni (1990) adopt this approach using money supply and interest rate innovations, respectively. Their results generally confirm the conclusions of the other studies: changes in German policy have a strong impact on other ERM members, but Germany itself is not immune to innovations in other countries. In particular, interest rate changes in the Netherlands, France and Italy-appear to have a strong effect on German rates, over different periods from 1979 to 1988. However, the study based on changes in base money, found that the effect of innovations in other ERM countries on Germany is only temporary.

Artus et al., (1991) estimated a more general model of interest rate determination for France and Germany, which allows for term-structure and exchange rate effects. They found strong evidence of asymmetry, with German short-term interest rates reacting mostly to the United States interest rates and the DM/US$ exchange rate, and France reacting to German interest rates, the Franc/DM exchange rate and the current account. Long-term interest rates were found to be weakly related to short-term rates but strongly related to foreign long-term rates.

On balance, it appears that the hypothesis of German leadership in the ERM, interpreted in a strict sense, is rejected by the above studies. To be sure, the ERM works asymmetrically, but innovations in other ERM countries affect German interest rates and monetary aggregates. However, as pointed out by Wyplosz (1989b), these results are not sufficient evidence to reject the hypothesis of German leadership. After all, even for a leader it is optimal to set policy on the basis of the actions of the other players. The alternative and less restrictive hypothesis of German independence may be a more appropriate and, according to the evidence discussed above, an empirically more accurate representation of the ERM.

Finally, two other approaches to analyzing asymmetry in the ERM deserve mention. First, in an interesting study, Mastropasqua et al., (1988) use information on foreign exchange interventions and sterilization to develop an alternative test of monetary independence. Under the hypothesis of monetary independence, changes in the net foreign asset position of a member country related to foreign exchange intervention using its currency should be fully sterilized. For the period 1979 to 1987, they found sterilization to be incomplete in the four ERM countries considered, except Germany, for which the hypothesis of full sterilization after three months could not be rejected. They also observed that, while Germany was responsible for nearly all net sales of dollars over the period 1979-87, it took almost no part in interventions in EMS currencies. This provides some evidence in support of German independence, since Germany appears to hold responsibility for the position of the ERM block relative to other currencies, but does not concern itself with the relative position of exchange rates in the band.

Second, in a recent study, Koedijk and Kool (1992) tested whether the ERM had acted as a DM zone by applying a principal components analysis to interest rate and inflation differentials within the EMS, i.e., including the United Kingdom, from 1979 to 1989. Specifically, they investigated whether dominant movements in bilateral interest rate and inflation differentials could be attributed to specific countries or group of countries. They found evidence of persistent independent interest rate and inflation differentials in the EMS originating from the independent movements in two currency blocks: Germany, the Netherlands and the United Kingdom, on one side, and France, Italy and Belgium, on the other; the independent movement of Irish interest rates was another important factor contributing to the overall variance. Although the authors concluded from this that the EMS has not functioned as a DM zone, it seems more appropriate to say that their analysis only rejects the restrictive hypothesis of German dominance.

II. Data and Sample Period

We investigate the issue of German leadership using changes in French and German one-month on-shore and off-shore interest rates sampled daily from October 1987 to August 1992. We choose to restrict our sample to the co-movement of these two rates, in order to present a fuller statistical analysis than would be possible in a broader system. We also believe that our choice of interest rates provides a sound basis for testing the hypothesis of German leadership. First, because France, since 1987, has been one of the most vocal EMS members calling for greater symmetry in the ERM and claiming a greater role for herself. Second, because other ERM members either possess financial markets too small to have much influence on those of Germany or France, or have already openly accepted German monetary leadership. The obvious exception is the case of the United Kingdom, which, however, only entered into the ERM in October of 1990, and then only with a much wider fluctuation margin. 2/

The use of daily data allows us to look for the presence of regime shifts in the later 1980s and early 1990s. In particular, we look for a structural break around the time of German unification. Such regime shifts are possible because the budgetary and monetary strains induced by unification may have weakened Germany’s anti-inflationary resolve, and thus eroded the leadership role of Germany in the ERM. We do not identify a breaking point in the data with any particular historical or news event, since movement towards German unification gained strength over several months. 3/ Rather, we chose to break our sample at the end of December 1989, when the turmoil of unification brought the deutsche mark under pressure in exchange markets.

The nominal convergence vis-a-vis Germany achieved by some ERM participants, notably France, over our sample period is viewed by some as another possible explanation for the erosion of German leadership after 1990. In our view, this development should not by itself lead to a regime shift. The improvement in inflation performance in France increased the credibility of French macroeconomic policy, and thus contributed to the reduction in interest differentials with Germany. However, increased credibility does not immediately confer greater independence; after all, the policy objectives of France did not change.

An important consideration in our selection of a sample period was to ensure that, unification apart, it included no obvious regime switches. Two points should be noted in this regard. First, our sample period begins after the last major realignment in the ERM of January 1987, in which the DM and the Netherlands guilder central parities were revalued by 3 percent, and the Belgian franc by 2 percent. After this realignment, French authorities adopted what became known as the “competitive disinflation” strategy, by which the competitiveness of the economy was to be restored by lowering inflation below that of ERM partners, rather than resorting to further devaluations vis-a-vis the DM and the stronger currency core. Because it precluded further devaluations vis-a-vis the deutsche mark, this strategy could have constituted a form of regime shift.

Second, the chosen sample period coincides with the new ERM rules of intervention and policy coordination formalized in the Basle-Nyborg agreement of September 1987. The Basle-Nyborg agreement represented a significant change in the rules regulating intervention within the ERM. The agreement permitted intramarginal intervention to be financed for the first time through the Very Short-Term Financing Facility (VSTF, i.e., a network of mutual credit lines between participating central banks). The agreement also stressed that greater fluctuation of exchange rates should be allowed within the band and that interest rate differentials should be used more aggressively to defend exchange rate parities. Under the original rules of the ERM, access to the VSTF was limited to interventions at the margin of the band. Since most interventions occurred intramarginally, the actions of the intervening country had no direct impact on the balance sheet of other central banks. 4/

Given the above discussion, we think it reasonable to regard the behavior of interest rates in our sample period to be homogeneous apart from the shock due to German unification. 5/ The high frequency sampling also distinguishes our study from the rest of the literature in that it permits us to detect dynamics in the data when policy response is very rapid. In fact, with the gradual dismantling of capital controls over our sample period, lags in the response of interest rates to foreign innovations are likely to have been reduced to a few days, at most. In this context, as mentioned above, statistical causality tests based on monthly observation are likely to lose too much information to be meaningful.

There is wide disagreement in the literature over the merits of using on-shore versus off-shore interest rates for empirical testing. In our study, we use both. The off-shore rates employed consist of one-month Euromarket deposit rates (Chart 1), while the on-shore rates are domestic one-month interbank rates. 6/ A potential disadvantage with the use of on-shore money market rates is that they are likely to be contaminated by domestic developments related to reserve requirements and other institutional factors. 7/ An indication of this problem is given by the much higher degree of autocorrelation present in on-shore interest rate data (Table 4). On-shore rates also display a much higher degree of kurtosis, suggesting the presence of larger jumps in on-shore rates (Table 1).

Chart 1.
Chart 1.

Off-Shore Interest Rates 1987-92

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

Table 1:

One-Month Interest Rates: Descriptive Statistics

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The problem with off-shore rates, in contrast, is that they may not fully reflect monetary policy actions by the authorities concerned, if capital controls are present. In the case of France, capital controls were in effect from 1987 through 1989, although they do not appear to have insulated the domestic market from foreign innovations to any significant degree. As reported in Table 2 and shown in Chart 2, the standard deviation of the French off-shore differential declined after the removal of capital controls, but was relatively small even in the first period (except for the end of 1987) when compared to the German off-shore differential. The off-shore differential rarely rose above 20 basis points for France, whereas persistent deviations of that magnitude are observed in the case of Germany. The lack of segmentation between the French on-shore and off-shore markets is also confirmed by Weber (1990), who found that, over the period 1983-1989, Granger causality ran clearly from French off-shore rates to French on-shore rates, and not vice-versa.

Table 2:

On-Share-Off-Shore Differences: Descriptive Statistics

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Note: the break in samples at unification coincides with the final removal of French exchange restrictions on 1/1/90.
Chart 2.
Chart 2.

Off-Shore Interest Rate Differential, 1987-92

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

The descriptive statistics reported in Table 3 reveal some more interesting information. First, the contemporaneous cross correlation between France and Germany in the on-shore markets is quite strong before January 1, 1990 (correlation coefficient of 0.57), but weakens substantially thereafter (0.09). In contrast, the correlation coefficient in the off-shore market remains quite stable over the two periods (0.15 and 0.16, respectively). Second, the contemporaneous correlation of off-shore and on-shore rates is weaker for Germany than for France in both subperiods. Again, both these observations raise doubts about the effectiveness of capital controls in insulating French monetary policy from external innovations before 1990. Admittedly, the correlation between on-shore and off-shore rates rises in France after 1990, but it does so to an even greater extent in Germany.

Table 3:

Cross Correlation Matrix of Interest Changes

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Finally, the cross autocorrelations (Table 4) between on-shore and off-shore rates as well as between French and German rates do not reveal the presence of any obvious one day temporal causality in the data, since the off diagonal elements (about the diagonal) of the cross autocorrelation matrix are all relatively similar (and also relatively small), i.e., the correlation between a lagged change in German rates and the current change in French rates is similar to the correlation between a lagged change in French rates and the current change in German rates.

Table 4:

Cross Autocorrelation Matrix of Data

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Note: entries are covariances withlagged variables scaled by standard deviations of the two series.

III. Estimation and VAR Identification

Consider a three-dimensional vector of interest changes for France, Germany and the United States. In the models we estimate, this vector of short interest rate changes is regressed on cross-country contemporaneous interest changes, five own lags of the interest change vector, and five lags of changes in benchmark long term interest rates for each country. In formulating a linear model of this kind, we ignore possible non-linearities due to band effects (see Krugman (1991), and Bertola and Svensson (1991)). Modelling interest rates with such effects explicitly accounted for is quite difficult. Recent empirical work (see, for example, Lindbeck and Soderlind (1991)) suggests that large-scale intramarginal intervention within the band by central banks makes such non-linearities relatively unimportant and Svensson (1991) argues that it is, therefore, legitimate to approximate a target zone using a linear model of a managed float. The approach in this paper can be justified in a similar manner. 8/ To identify the model statistically, we assume (i) that German and French interest rates are not directly affected by each others’ long term interest rates (i.e., exclusion restrictions), (ii) that the United States interest rates are not affected by changes in French or German rates at any lag (i.e., exclusion restrictions), and (iii) that the covariance matrix of innovations to the system are orthogonal instantaneously (i.e., covariance restrictions). These assumptions imply that the model is overidentified. 9/ Assumption (iii) implies that all instantaneous cross-correlation between short-term interest rates occurs through the matrix of coefficients on contemporaneous interest changes. Define Xt≡(XtF|XtG|XtUS)′ as a three-dimensional vector of short interest rate changes for, and Yt≡(YtF|YtG)′ a two-dimensional vector of changes in French and German long rates. The models we estimate are then of the form:

Xt=AXt+Σi=15BiXt−i+Σi=15CiYt−iεt(1)
whereA≡[0a12a13a210a23000]Bi≡[b11ib12ib13ib21ib22ib23i00033i]Ci≡[c11i00c22i00](2)

where ∑*= Cov(εt) is unrestricted and ∑*= Cov(εt) is assumed to be diagonal.

Estimation was carried out using the approach of Generalized Method of Moments (GMM). 10/ The descriptive statistics given in Table 1 suggest that interest rate changes are extremely leptokurtic 11/ suggesting that Maximum Likelihood (ML) estimation based on normal distributions would be inadvisable and that a more robust estimation method such as GMM is to be preferred. 12/ The models were each initially estimated using an arbitrary weighting matrix. The resulting consistent parameter estimates were then used to construct an optimal weighting matrix based on the Newey-West approach 13/ to covariance matrix estimation. The latter was then employed in a second iteration of GMM to obtain asymptotically efficient parameter estimates.

In our initial estimations, we also included three dummy variables that took the value unity if one of the markets in question had been closed one, two or three or more days preceding a given observation, and otherwise were zero. Most studies of financial market data ignore weekends and holidays on the presumption that what matters is some notion of “economic time” reflecting periods in which markets are open. Since these dummies proved insignificant, they were dropped from the version of the regressions actually reported. Rather than looking on the statistical significance of the regression coefficients either individually or in groups, we regard it as more interesting to focus on the significance, both economic and statistical, of the long-run multipliers implied by the regression equations. Such long-run multipliers take into account feedback both within a given equation and within the system as a whole. We calculate two sorts of long-run multipliers. The first incorporates all feedback within the system, while the second limits feedback to within a single equation. To calculate the first of these, one must convert the system into a vector autoregression of order 1 of the form:

[XtXt−1⋮Xt−4]=[(I−A)−1B1(I−A)−1B2…(I−A)−1B5I0¯…0¯0¯I…0¯⋮⋮⋱⋮0¯0¯0¯I][Xt−1Xt−2⋮Xt−5]+[ε′t0¯⋮0¯](3)

where I is a three-by-three identity matrix, 0 is a three-by-three matrix of zeros, and where εt′≡(I−A)−1εt. If one denotes the coefficient matrix on the right hand side of the above equation by Φ, then the long-run multipliers for shocks to the different interest rate are given by the upper three rows of: (I15-Φ)[(I-A)1|0…|0]′, where I15 is a fifteen-dimensional identity matrix. We also calculate simpler equation-by-equation multipliers of the form:

(ajk+Σi=15bjki)/(1−Σi=15bjji). Using the fact that these multipliers are complicated, non-linear functions of the parameters, their standard errors and t-statistics are calculated based on the covariance matrix of the parameters. The latter equals inv ((∂q/∂θ)′∑q(∂q/∂θ)), where ∂q/∂θ is the derivative of the sample averaged moment conditions with respect to the parameters and ∑ is a Newey-West kernel estimate of the covariance matrix of the moment conditions.

IV. Results

1. VAR estimates and Impulse effects

Tables 5-8 and Charts 3-6 show the long-run effects of unit shocks in French, German and the United States short-term interest rates. Single equation and system wide multipliers differ because the former ignore feedback effects between equations. 14/

Table 5.

SYSTEM-WIDE LONG-RUN EFFECTS: EURO-RATES

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NB: in each matrix of multipliers, the column indicates the origin of the shock and the row shows the interest rate affected.
Table 6:

EQN-BY-EQN LONG-RUN EFFECTS: EURO-RATES

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NB: in each matrix of multipliers, the column indicates the origin of the shock and the row shows the interest rate affected.
Table 7:

SYSTEM-WIDE LONG-RUN EFFECTS: NATIONAL RATES

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NB: in each matrix of multipliers, the column indicates the origin of the shock and the row shows the interest rate affected.
Table 8:

EQN-BY-EQN LONG-RUN EFFECTS: NATIONAL RATES

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NB: in each matrix of multipliers, the column indicates the origin of the shock and the row shows the interest rate affected.
Chart 3.
Chart 3.

Effect of Unit Interest Rate Shocks Off-Shore Interest Rates, Pre- and Post-German Unification

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

Chart 4.
Chart 4.

Effect of Unit Interest Rate Shocks Off-Shore Interest Rates, Whole Sample and 1990 Only

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

Chart 5.
Chart 5.

Effect Unit Interest Rate Shocks On-Shore Interest Rates, Pre- and Post-German Unification

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

Chart 6.
Chart 6.

Effect of Unit Interest Rate Shocks On-Shore Interest Rates, Whole Sample and 1990 Only

Citation: IMF Working Papers 1992, 096; 10.5089/9781451949988.001.A001

The system wide Euro-rate long-run multipliers (Table 5), clearly reject the hypothesis of German dominance, i.e., uni-directional causality, for the whole sample. The effect of French innovations on Germany is significant, albeit smaller than the German effect on France.

However, the results strongly suggest the presence of a structural break coinciding with German unification. In the pre-unification period (1987 through 1989), the German multiplier for France is 0.27 compared with a French multiplier for Germany of 0.11. After unification, the corresponding figures are 0.21 and 0.18. Examining the year-by-year estimation results, we find that the post-unification period is very uneven, with Germany losing its leadership role entirely during 1990, and recovering it after that.

Innovations in U.S. interest rates affect only German Euro-rates to any significant degree. A unit shock to the United States rates leads to a 27 basis points rise in German off-shore rates in the long-run. The direct and feedback effects of U.S. rate changes on France are extremely small and not statistically different from zero.

The equation-by-equation multipliers given in Table 6 (that ignore cross-equation feedback effects), broadly resemble the system-wide multipliers of Table 5 although the magnitude of German interest rate innovation multipliers is greater. The reason is that the mean-reverting tendency of German rates mutes the long-run effects of a German innovation on French rates in the system-wide multiplier compared with the single equation case.

System wide multipliers using on-shore rates again give similar results, although they display more symmetry in the pre-unification period and greater asymmetry in 1991-1992 (Table 7). This difference could be related to the presence of capital controls in the pre-unification period, which insulated French domestic interest rates somewhat from foreign innovations. With their elimination at the beginning of 1990, national markets have become more integrated and, possibly because national markets reflect more closely the monetary authorities actions, they may also have become more responsive to each other’s innovations. The second main difference between the on-shore and off-shore results is that German interest rates are not mean-reverting (Table 8).

As was noted above, the long-term response of interest rates to a unit shock in the same rate varies across equations and often differs from unity. Hence, it does not necessarily translate into a permanent unit change in that interest rate. Monetary policy actions, however, cannot easily be described in terms of unit shocks. A more realistic description of a monetary policy change is a one time permanent change in short-term interest rates. In Table 9, we therefore report the effects of unit permanent changes in French and German interest rates on each other, based on the estimated coefficients of Tables 5 and 7. This presentation also allows us to measure cross effects based on the same monetary action, rather than on the same temporary shock in the two equations.

Table 9:

IMPACT OF UNIT PERMANENT ΔrF AND ΔrG

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NB: entries equal ratios of cross to own long-run multipliers.

The results generally confirm the conclusions drawn above: German monetary policy actions have a stronger effect on France than vice versa in the pre-unification period, although to a significant degree only for off-shore rates. In the first year of German unification, the roles are reversed and France assumes the leadership role, particularly for on-shore rates. However, Germany appears to regain its stronger role in 1991-1992.

2. Tests for structural instability

Table 11 gives Lagrange Multiplier tests for structural breaks in the sample. The tests take account of the fact that the switch point is unknown. The statistics given represent the maximum of a series of Lagrange Multiplier statistics calculated for various alternative switch dates. This approach for testing for breaks of unknown date has been in general use for nearly thirty years but it is only very recently that the true distribution of the test statistic has been established. Andrews (1990) and Hansen (1990) derive the distribution of such ‘Lagrange Multiplier supremum’ statistics.

Table 10:

EQN-BY-EQN LONG-RUN LONG RATE MULTIPLIERS

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Table 11:

Lagrange Multiplier Tests for Structural Change

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NOTES: * indicates significant at 5% significance level. Dates respresent the sample breaks that give the maximum LM statistics. Test 2 concerns all French and German parameters. Tests 3 and 4 concern parameters for impact of German rates on French and vice versa.

Since our prior is that German unification led to a major change in behavior followed by a gradual return to normality, we consider two samples, October 1987 to December 1990, and January 1990 to August 1992 and test for structural breaks of unknown date in each case. We implement the tests by calculating the statistics for a range of switch points at every twenty observations to each side of end December 1989 and 1990 respectively for the two samples. In each case, we extended the range of possible switch points to cover most of the sample in question. We then took the maximum value of the calculated statistics and compared it with the significance levels given in Andrews (1990) and Hansen (1990).

The results suggest that a big change did occur at the end of 1989. The Lagrange multiplier tests for the October 1987 to December 1990 period are all significant at a 5 percent level except for one. 15/ All the switch points suggested by the significant tests are within twenty observations of the start of January 1990.

Tests for the later sample of January 1990 to August 1992 show much less evidence of regime breaks, although the test for a change in all the parameters is significant at a 5 percent level. The date around which this switch seems to have occurred is February 1991. This suggests that while there is some return to the situation prevailing before December 1989, the change is less marked and perhaps less clearly focused at a given moment in time.

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1/

We thank Leonardo Bartolini for helpful comments. The views expressed in this paper are those of the authors and do not necessarily reflect those of the International Monetary Fund. Part of the work for this project was done while Mr. Perraudin was a visiting scholar in the European I Department of the Fund.

2/

The range of permitted fluctuation above and below the central rates is 6 percent for sterling and the Spanish peseta and 2.25 percent for the other participating currencies.

3/

The first impulse to German unification was given by the mass emigration from the German Democratic Republic (GDR) to West Germany that followed the opening of the border between Hungary and Austria, in September 1989. With the opening of the border between the two Germanies in November of the same year, the volume of people moving from the GDR took on massive proportions, bringing into question the viability of the GDR as a separate nation. A currency union between the two Germanies was proposed by Chancellor Kohl in February 1990 and the final terms of unification were negotiated in April and May 1990. For a further discussion of these events and their economic effects, see Lipschitz and McDonald (1990).

4/

The Basle-Nyborg agreement caused some concern in Germany that the obligation to finance intramarginal interventions could lead to excessive liquidity creation by the Bundesbank, thereby undermining the anti-inflationary stance of German monetary policy. Several factors reduced this risk, however. First, intramarginal intervention using a partner’s currency still requires the prior approval of the central bank issuing the intervention currency, and, second, the amounts involved are small relative to the total monetary base. Moreover, with most central banks using interest rates as intermediate targets, the monetary effects of intervention tend to be automatically sterilized. Following the ERM crisis of September 1992, Germany, for the first time, intervened intramarginally in support of another ERM currency, i.e., the French franc. This is more likely to reflect the gravity of the strains within the ERM at the time, than a change in Germany’s role in the ERM.

5/

Of course, German unification occurred at the same time as Eastern Europe as a whole began its process of reform. Flows of net investment to Eastern Europe, except to the former Eastern Germany, have remained fairly negligible, however, and it is hard to believe that the more general reform process has significantly affected monetary events in the Western economies.

6/

Interbank rates have the advantage that their tax-exempt status insulates them from the effect of changes in taxation.

7/

For example, regular movements in rates associated with bank reserve accounting periods introduce negative autocorrelation that has nothing to do with the dynamics of genuine shifts in monetary policy, obscuring actual policy changes.

8/

One might, nevertheless, argue that we should include lagged exchange rate changes in our regressions. Our initial estimations did include such lagged changes but they had no significant explanatory power so we felt justified in omitting them.

9/

(i) and (ii) would be sufficient to identify all but one of the parameters. For discussion of identification in linear models with covariance restrictions, see Hausman and Taylor (1983), and Hausman et al., (1987).

10/

See, for example, Gallant (1987).

11/

On-shore rate changes exhibit kurtosis ranging up to almost 200 compared to the kurtosis of any normal random variable of 3.

12/

Artus et al., (1991) use ML on monthly data. While monthly interest changes may be somewhat closer to normal random variables, ML is still probably inappropriate.

14/

Note that we ignore possible feedback effects through changes in long interest rates. According to Artus et. al., (1991), French and German long-term rates are only weakly affected by movements in short-term rates.

15/

The one for U.S. rate effects on French and German rates.

Same Series

Other IMF Content

Other Publishers

Cover IMF Working Papers
Asymmetry in the ERM: A Case Study of French and German Interest Rates Since Basle-Nyborg
Author: Mr. W. R. M. Perraudin and Mr. E. H. Gardner
Volume/Issue:
Volume 1992: Issue 096
Publisher:
International Monetary Fund
ISBN:
9781451949988
ISSN:
1018-5941
Pages:
53
DOI:
https://doi.org/10.5089/9781451949988.001