Real Interest Rate Linkages: Testing for Common Trends and Cycles

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate
Published on 17 July 1997

Working Paper No. 65
By Darren Pain and Ryland Thomas

This paper formed part of the Bank of England’s contribution to a study by the G10 Deputies on saving, investment and real interest rates, see Jenkinson (1996). It investigates the existence of common trends and common cycles in the movements of industrial countries’ real interest rates. Real interest rate movements are decomposed into a trend (random walk) element and a cyclical (stationary moving average) element using the Beveridge-Nelson decomposition. We then derive a common trends and cycles representation using the familiar theory of cointegration and the more recent theory of co-features developed by Vahid and Engle (1993). We consider linkages between European short-term real interest rates. Here there is evidence of German leadership/dominance - we cannot reject the hypothesis that the German real interest rate is the single common trend and that the two common cycles are represented by the spreads of French and UK rates over German rates. The single common trend remains when the United States (as representative of overseas rates) is added to the system, but German
leadership is rejected in favour of US (overseas) leadership. We also find the existence of a single common trend in G3 rates after 1980.

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