The relationship between interest rate differentials and macroeconomic variables: a panel data study for European countries

Abstract

Based on panel data regressions the relationship between 12 month interest rate differentials and macroeconomic variables is analyzed for nine European countries relative to Germany. Stationarity properties of the variables are examined by tests developed for panel data models. The distribution of the test statistic is not normal and is bootstrapped from the sample at hand. All significant regression coefficients are estimated with the predicted sign. In particular, the inflation differential, the real income growth differential, relative labor costs, and the current account have a strong effect on the interest rate differential. Hence the results indicate that governments have some scope for influencing the interest rate differential by conducting the appropriate macroeconomic policy. These results are considerably more optimistic compared to earlier studies, where interest rate differentials are frequently measured at 1 month and 3 months maturity. Included also is an analysis of whether the ERM countries have gained more credibility in exchange rate policy through the exchange rate system.