Interest Rates Linkages within the EMS: What Lies Ahead for the Euro

Abstract

This paper applies multi-equation cointegration methodology to the short-term interest rate series of European Monetary System (EMS) member countries during the period from March 1979 to July 1998. The objective of the paper is to measure the degree to which the interest rates of EMS member countries moved together and whether they exhibited different trends over the period. The behavior of the interest rates provides a test of the EMS' performance in coordinating member country interest rates. The results based on the performance of the EMS yield information about future prospects for the Euro and about the future impacts of the single European currency on member countries. Our results show that interest rates of EMS member countries conformed to a long-term equilibrium relationship between 1979 and 1998. The equilibrium relationship is stronger before the 1992 crisis, and loses its strength after 1992. Based on the lack of coordination of interest rates under the EMS system, the introduction of the Euro will impact the credit markets of ECU members differently and complicate, monetary policy decision-making by the European Central Bank.