Dynamics of Intra-EMS Interest Rate Linkages

A number of previous studies have questioned the dominant role of Germany within the EMS. These conclusions are often based on empirical findings that interest rates of member countries of the EMS are not affected by German interest rates, even in the long run. In this study we establish evidence to the contrary by demonstrating that intra-EMS interest rate differentials (vis-a-vis Germany) exhibit mean-reverting behavior (a necessary but not sufficient condition for German dominance) characterized by long-memory dynamics. In a system incorporating six EMS countries and one non-EMS country (the U.S.), estimates from a fractional error correction model suggest the presence of short-run intra-EMS monetary-policy interdependencies, but they validate the German Dominance Hypothesis in the long run.