A Convergence Model of the Term Structure of Interest Rates

This paper develops a convergence model of the term structure of interest rates in the context of entering the EMU. Compared with the other models developed so far in this field, our model specification ensures convergence of the domestic short-term interest rates to the euro area ones. We achieve this convergence by stating that the spread between the domestic and euro short-term interest rates follows the Brownian bridge process. We also develop an econometric counterpart of the theoretical model. To address the problem of nonstationarity and nonlinearity of the model, the extended Kalman filter for coefficient estimation is applied.