Interest linkages between the US, UK and German interest rates: should the UK join the European Monetary Union?

Abstract

In light of continuing mixed results in the literature, this paper re‐examines the German Dominance Hypothesis (GDH) and considers whether the UK should join the Eurozone. For this purpose, short‐term interest rate relationships between the UK, Germany, the Eurozone and the USA, for the period January 1982 to June 2007, are studied. The policy implication of a loss of monetary autonomy for the UK in favour of Germany or the European Central Bank (ECB) would give support to the UK joining the EMU as an economic response. From the early 1980s the Bundesbank’s responsibility was to use money growth targets to keep average inflation rate down in the long run. This long run objective suggests that an appropriate methodology for testing the GDH is to test whether the German stochastic trend is a driving stochastic trend. In other words we determine whether a permanent shock to the German interest rate has a permanent effect on the UK interest rate. To this end the structural shocks in a VECM are identified by imposing long‐run restrictions of the type developed in King et al. (1991). We apply the same techniques to testing whether the UK has suffered a loss of monetary autonomy in favour of the ECB.

Keywords:

• Exchange Rate Mechanism
• interest rates
• vector error correction models

JEL Classifications:

• C32
• C52
• E43

Notes

1. See for instance the recent discussion in Liu and Pappa (2008).

2. Fisher, Fackler, and Orden (1995) and Fisher (1996) provide an exposition of the KPSW procedure to identify the structural shocks with permanent effects in an estimated VECM.

3. For descriptions of these tests see, respectively, Phillips and Perron (1988), Dickey and Fuller (1979) and Kwiatowski et al. (1992).

4. The program CATS in RATS was used to obtain all the estimation results reported in the paper (Dennis 2006).

5. See Sardoni and Wray (2006, 454).

6. See Sardoni and Wray (2006, 455) for this argument and for further discussion.

7. To support this point of view Sardoni and Wray (2006) argue that as ‘… the minutes of the June 30, 2004, meeting make clear, the FOMC’s decision to raise rates was based largely on the market’s expectation that rates would be raised.’ Sardoni and Wray (2006, 459, emphasis added).

8. A European Central Bank document, quoted in Sardoni and Wray (2006, 461), remarks that: ‘… given that monetary policy can affect real activity in the shorter term, the ECB typically should avoid generating excessive fluctuations in output and employment if this is in line with the pursuit of its primary objective [price stability].’