Interest rate linkages within the European Monetary System: new evidence incorporating long-run trends

Abstract

This paper shows that the rejection of the existence of bivariate long-run relationships between the interest rates within the European Monetary System (EMS), by previous studies, may stem from the under-specification of deterministic variables in the models and failure to capture the changes in the trend behavior of the data. The present study applies the Johansen cointegration tests in models with alternative trend specifications to four German-other EMS interest rate pairs for 1979–1998 with three sub-sample periods corresponding to different degrees of EMS monetary integration. In contrast to the findings of past studies, the results of this study lend support to the hypothesis that the interest rates of EMS countries move together more closely over time, converging from a wide dispersion toward the central level.