Real interest parity, dynamic convergence and the European Monetary System

Is further economic convergence between European Monetary System (EMS) member countries desirable? This paper addresses some of the convergence issues currently being raised in the debate over Economic and Monetary Union (EMU) in Europe, with particular emphasis on the behaviour of real interest rates. The important distinction between static and dynamic convergence is highlighted. A standard analytical framework is presented which illustrates the importance of the components of the real interest differential - namely capital controls, risk premia and the real exchange rate - as endogenous mechanisms for the transmission of policy. As such, variations in the real interest differential are shown potentially to be important for ensuring dynamic convergence to a steady-state EMU.