Abstract
The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Summary of WP/92/96
“Asymmetry in the ERM: A Case Study of French and German Interest Rates Since Basle-Nyborg” by E.H. Gardner and W.R. Perraudin
This paper analyzes empirically how Germany’s leadership role has evolved in the exchange rate mechanism (ERM) of the European Monetary System since the Basle-Nyborg Agreement of September 1987 by examining the joint behavior of French and German short-term interest rates. The Basle-Nyborg Agreement was chosen as the starting point because it represents a significant change in the rules regulating intervention in the ERM. This study, unlike others, uses daily sampling to detect the presence of regime shifts--in particular, structural breaks around the time of German unification--over this shorter period.
There is wide disagreement in the literature over the merits of using onshore versus offshore interest rates for empirical testing. On the one hand, offshore rates have the advantage of not being contaminated by domestic developments related to reserve requirements and other institutional factors. On the other hand, onshore rates are more likely to be influenced by the monetary policy actions of the authorities concerned in the presence of capital controls. In light of these problems, this study uses both rates.
In the estimated models, a vector of daily changes in French, German, and U.S. short-term interest rates is regressed on cross-country contemporaneous interest changes, on five own lags of the interest change vector, and on five lags of changes in benchmark long-term interest rates for each country. To identify the model, it is assumed that (1) French and German interest rates are not directly affected by each other’s long-term interest rates; (2) U.S. interest rates are not affected by changes in French and German rates; and (3) the covariance matrix of innovations to the system are orthogonal instantaneously. The Generalized Method of Moments is used to estimate the model.
The results for the whole sample (October 1987-August 1992) reject German dominance --unidirectional causality-- thereby confirming the general findings of other authors. The effect of France 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 news of German unification, that is, at the end of 1989. Before unification, the system clearly works asymmetrically, with German monetary policy actions having a stronger effect on France than vice versa, although, to a significant degree, only for offshore rates. In the first year of German unification, France assumes the leadership role, particularly for onshore rates. However, Germany appears to regain its leadership role in 1991-92.