Dynamic Linkages of Interest Rates Within Ems: Implications for the 'German Dominance' Hypothesis and Monetary Policy

Abstract

This paper explores the nature of the interaction of short- and long-term interest rates within the European Monetary System for the period 1979-1999. The empirical examination centers on the 'German Dominance' hypothesis which purports that German interest rates should convey valuable information to the other EMS countries' interest rates behavior. In other words, it is assumed that there exist uni-directional volatility spillovers from the Bundesbank to the other countries' central banks. The methodology employed is the multivariate framework of the EGARCH model which is capable of capturing the potential asymmetries and other anomalies of the volatility transmission mechanism. The results do not support the dominance hypothesis, in a strict sense, since Germany's monetary policy is influenced by the actions of its partners, especially since 1990. Finally, the implications for a European Union monetary policy are highlighted.