Interest rate linkages: a Kalman filter approach to detecting structural change

Abstract

This paper investigates changes in the causal structure linking of the G-7 short-term rates by estimating time-varying speed of adjustment coefficients in error correction equations using a Kalman filter approach. This technique allows us to detect structural breaks in the causal linkages that generate the cointegrating relations between the series. The testable hypotheses are the US world-wide leadership, the disengagement of UK monetary policy from those pursued in the Eurozone after the collapse of the ERM and the German leadership hypothesis (GLH) within the European Union (EU). The evidence points to a break in the causal linkages between the UK and other EU countries after the third–fourth quarter of 1992. The empirical results are also consistent with a US world-wide leadership and a weak German leadership within the Eurozone.