Inflation and Interest Rate Differentials Between Germany and its EMS Partners

Abstract

Uncovered interest parity and purchasing power parity suggest an equilibrium relationship between inflation and long-term interest rate differentials. In this paper we investigate the time trend properties of these differentials for the EMS members vis-à-vis Germany. The results of unit root tests indicate that for the Netherlands and for Austria both differentials are stationary while for Belgium and France we find a cointegration vector that represents the hypothesized relationship. Causality tests provide empirical evidence that inflation differentials generally Granger-cause interest rate differentials. For specific countries we also find Granger causality from interest rate to inflation differentials for the period before 1985. These results support the view that the credibility of monetary and fiscal policies plays an important role in determining the reaction of bond markets to inflation.