On real interest rate convergence among G7 countries
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On real interest rate convergence among G7 countries Jana Riedel1 Received: 31 December 2015 / Accepted: 4 March 2019 © Springer-Verlag GmbH Germany, part of Springer Nature 2019
Abstract I analyze real interest rate convergence among six industrialized countries in 1975M1– 2011M3 within a multi-country framework by means of a dynamic latent factor model. This approach makes it possible to examine common trending behavior and common transitory movements in the real interest rates. Time-varying variances of the components allow for gradual endogenous transition from a high variance regime toward a low variance regime. The estimation results suggest that four permanent and four transitory components capture the real interest rate dynamics among the sample of G7 countries at the beginning of the sample period. The common components’ variances mostly decline over time, and in part even converge to values close to zero. This indicates a reduction in the number of stochastic factors, which in turn can be interpreted as confirmation of the convergence hypothesis of less cross-country dispersion over time. I observe rapid convergence during the late 1970s and 1980s, followed by slower transition since the beginning of the 1990s when financial markets had already been highly integrated. Keywords Latent dynamic factor model · Unobserved components · Real interest rate parity · Financial market integration · G7 JEL Classification C32 · F36 · F32 · E43
I thank especially Tino Berger, and also Bernd Kempa, Joscha Beckmann and Ralf Brüggemann, and two anonymous referees, and the participants of the 15th IWB workshop, the 3rd IWH/INFER workshop, the 4th ZEW Conference on Recent Developments in Macroeconomics, the XIV Conference on International Economics, the ESEM-EEA 2013, and the Jahrestagung des Vereins für Socialpolitik 2013 for valuable comments on earlier versions of this paper.
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Jana Riedel [email protected] Department of Economics, Institute of International Economics, University of Münster, Universitätsstr. 14-16, 48143 Münster, Germany
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J. Riedel
1 Introduction The behavior of real interest rates among countries has been and still is an important question in international monetary economics. Standard monetary exchange rate models (see Frenkel 1976; Dornbusch 1976; Frankel 1979) are frequently based on the assumption of real interest parity (RIP). This implies two conditions, perfect capital mobility and perfect price adjustment for goods, services and factors of production. Thus, if financial and goods markets are perfectly integrated, i.e., the uncovered interest rate parity (UIP) and the purchasing power parity (PPP) do hold jointly, real interest rates must equalize among countries. In the 1970s and early 1980s, de jure integration of financial markets took place in several developed countries. Capital controls were loosened in 1973 in the USA and Germany after the Bretton-Woods breakdown, later in 1976 in the UK and Japan, and in 1986 in Italy and France. Thus, considering this financial
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