German dominance in the EMS: evidence from interest rates

Journal of International

.Cfone.v and Finance (1990). 9, 358-375

German dominance in the EMS: evidence from interest rates JURGEN VON HAGEN AND MICHELE FRATIANNI*

Graduate School of Business, Indiana University, Bloomington, USA

Indiana 47405,

The paper presents an empirical analysis of German dominance and asymmetries in the EMS based on a dynamic system of equations explaining national money market interest rates. The hypothesis of strict German dominance of the EMS is rejected. However, there are some noticeable asymmetries in the EMS. Germany is a relatively strong player and has been the least dependent country in the early phase of the system. Since 1983, German independence has diminished. In contrast, France throughout and Italy in the early phase of the EMS have been relatively weak players in the system.

the European Monetary System (EMS) was founded in 1978 among Belgium, Luxemburg, Denmark, France, Germany, Ireland, Italy, the Netherlands, and the UK, its creators envisioned a new kind of exchange rate arrangement, flexible enough to support different inflation trends for the member countries, and symmetric enough to make all members share in the burden of adjustment to eliminate balance of payments disequilibria.’ Based on the principles of symmetry and flexibility, the EMS would leave each member the freedom to choose its own, most preferred inflation rate. Today, the prevailing view of the EMS among economists and policymakers rejects this vision. In sharp contrast to the original intentions, the EMS is generally regarded as an asymmetric system, which is dominated by the German Bundesbank. We will call this view the German Dominance Hypothesis, GDH. GDH claims that the EMS is a coercive arrangement forcing the other members to follow the disciplinary, low-inflation policy rule of the Bundesbank. EMS membership has meant for these countries to surrender (part of) their monetary policy autonomy to the leadership of the Bundesbank. For example, Katseli (1987) argues that ‘within Europe, domestic central banks have chosen to lose some of the “economic effectiveness” of domestic monetary policy and accept the leadership of the Bundesbank.. ..’ Fisher (1987, p. 41) describes the EMS as ‘an arrangement by France and Italy to accept German leadership, imposing constraints on their domestic monetary and fiscal policies.’ When

* Respectively, Assistant Professor and Professor of Business Economics and Public Policy. This paper was written while Jiirgen van Hagen was a Visiting Scholar at the Federal Reserve Bank ofSt. Louis. Helpful comments from two referees are gratefully acknowledged. 0261-5606/90,‘04/0358-18

6

1990 Butterworth-Heinemann

Ltd

J~;RGEN VON HAGEN AND MICHELE FRATIANNI

359

Giavazzi and Giovannini (1987, p. 237) assert that ‘Germany is the centre country and runs monetary policy for the whole system.’ Russo and Tulio (1988, p. 50) argue that ‘Germany’s role in the EMS is similar to the role of the United States under the Bretton Woods system. . . . As a corollary, the asymmetry noted above in the working of the Bretton Woods system is also present in the EMS . . . .’ Gros and Thygesen (1988, p. 62) conclude that the ‘EMS has thus become a hierarchic and asymmetric system.’ Recently, the common perception of German dominance has been challenged by a number of studies testing the empirical implications of GDH. Fratianni and von Hagen (1990a, b) estimate systems of equations explaining monetary base growth in the EMS and show that the restrictions implied by GDH are rejected by the data. De Grauwe (1988) analyzes the responses of Belgian, Dutch, French, German, and Italian short-term interest rates to expected devaluations and concludes that the evidence does not support GDH. Cohen and Wyplosz (1989) use vector autoregressions to demonstrate that German interest rates and monetary base growth rates have significant effects on the same variables in Belgium, France, and Italy, but the reverse is also true. Mastropasqua et al. (1988) report a similar finding. These results are consistent with von Hagen’s (1989) conclusion that the Bundesbank does not, in general, sterilize foreign exchange market interventions completely, although, due to the characteristics of her operating procedure, the monetary effects of interventions manifest themselves only with a time lag. Finally, Fratianni and von Hagen (1990a) review the historical account furnished by Funabashi (1988) concerning the efforts of the G5 countries (France, Germany, Japan, the United Kingdom, and the United States) to stabilize the value of the dollar between 1985 and 1987. This review gives little support to the hypothesis of German dominance, specifically that the Bundesbank forced a G5 dollar policy on the rest of the EMS countries (Sarcinelli, 1986). On the contrary, the records portray the Bundesbank as a reluctant player in the G5 cooperative arrangement and worried about the consequences of official interventions for the stability of the EMS. This paper provides further evidence on the issue of German dominance in the EMS. In Section I, we review the credibility hypothesis according to which high-inflation EMS countries have accepted German dominance because they obtain greater credibility of their commitment to price stability in return. Our position is that this hypothesis does not yield a satisfactory explanation of the EMS. In Section II, we set up an empirical system of equations explaining short-term national money market interest rates in the EMS. Policymakers commonly express and judge the short-run effects of monetary policy actions on the basis of short-term interest rate movements. Such a model should therefore mimic the short-run policy game being played in the EMS. We derive and test restrictions on the system implied by GDH. Section III gives a quantitative assessment of German dominance and EMS asymmetries exploiting the interest rate response functions of our model. The main results and conclusions are summarized in the final section. I. Credibility

and German

dominance

Why would other countries in the EMS accept German dominance

After all, each country

in the system has retained

the option

of the system? of leaving the

360

Grrrmn

rkmintmc~e in rile E.LIS

arrangement if its consequences were perceived to be inconsistent with its own monetary policy goals. Applying Barro and Gordon’s (1983) seminal analysis of credibility to the EMS, Giavazzi and Giovannini (1987. 1988), Giavazzi and Pagan0 (1988), and Melitz (1988), among others, argue that the Bundesbank has a relative advantage among EMS countries to announce and pursue a credible low-inflation policy. The Bundesbank’s high credibility stems from her strong and proven preference for price stability over short-run employment gains and her relatively large degree of political independence. Other EMS central banks, in contrast, find it more difficult to announce similar policies on their own initiatives. Victims of their inclination to ‘buy’ temporary rises in employment at the expense of higher inflation and their greater dependence on government politics, the other central banks are locked in a high-inflation equilibrium: wage and price-setters do not regard the announcement and implementation of a low-inflation policy as credible. Although there are no employment gains from inflation, inflation is high and persistent in these countries because the alternative of a low-inflation policy rule is not an equilibrium strategy. The idea behind the credibility hypothesis is quite simple. By linking their currencies to the Deutsche Mark, other EMS central banks hand their policy autonomy over to the Bundesbank and thereby make their new commitment to a lower equilibrium inflation rate credible. This reduces the disinflation costs relative to the alternative of a restrictive monetary policy carried out independently of the Bundesbank. There are, however, several flaws with this hypothesis. First, it neglects the impact the EMS has on Germany’s optimal policy and, consequently, the Bundesbank’s own credibility. Giavazzi and Giovannini (1987), Giavazzi and Pagan0 (1988), and Melitz (1988) all assume that the Bundesbank’s policy is the same inside and outside the EMS. But Fratianni and von Hagen (1990a) demonstrate that the EMS changes the Bundesbank’s policy constraints in a critical way: under fixed exchange rates, the inflation consequences of a German monetary expansion are partly ‘exported’ to the EMS partners. The inflation cost ofa German monetary expansion is therefore lower in the EMS and, consequently, the Bundesbank’s incentive for monetary surprises increases. Recognizing the new incentives, the public reacts by revising and increasing its inflation expectations. This implies that the German equilibrium inflation rate rises and that the EMS inflation rate is higher than Germany’s inflation rate outside the EMS. Consequently, Germany loses from the EMS. With a lower German credibility and higher German inflation in the EMS, the credibility gain for the other members becomes ambiguous. There are two possibilities. If the German inflation rate in the EMS is still relatively low, the other countries can gain credibility, but they do so at the expense of Germany. However, the German inflation rate in the EMS may exceed even the other countries’ inflation under flexible exchange rates, so that no country gains credibility.’ Even if the other members gain from the EMS, proponents of the credibility hypothesis need additional reasons why Germany would accept the costly role of leadership. The answers that have been discussed in the literature do not seem fully convincing. There may be no benefits to the Bundesbank at all, if membership in the EMS was imposed on her by the German government (Fratianni, 1988). German law gives the Ministry of Finance the authority to determine exchange rate arrangements of the country. Indeed, it took an unprecedented visit to the

JORGES VOX HAGEN AND MICHELE FRATIANW

361

Bundesbank Council of German chancellor Helmut Schmidt in 1978 to overcome the Bank’s strong opposition to the EMS. As Norbert Kloten, member of the Council, recently put it, ‘the Bundesbank never wanted a dominant role in Europe’s monetary policymaking . . . She was forced to accept that role’ (1988, p. 3). But this view only redirects the question: what benefit does the German government seek to obtain from an asymmetric EMS? Credibility considerations clearly suggest that the government should preserve the Bundesbank’s independent position under flexible rates. Giavazzi and Giovannini (1987) argue that intervention rules in the EMS free the Bundesbank from the necessity to adjust to intra-European portfolio shocks. Their point, however, that the bulk of interventions are carried out by central banks other than the Bundesbank is relevant only foF intra-marginal interventions, which are not compulsory in the EMS.3 For compulsory interventions, in contrast, the working of the European Monetary Cooperation Fund (EMCF) assures that their monetary effects are the same in all countries, regardless of who actually buys or sells foreign exchange (Botinger, 1988). The Bundesbank may have accepted her leading role in the EMS in exchange for greater financial integration among the members. Historically, the DM has been more exposed than other European currencies to speculative capital flows originating in the dollar market. Under fixed exchange rates and integrated financial markets, speculative capital flows would be more evenly distributed in the region. The difftculty here is that, particularly around realignments, the working of the EMS depends heavily on the existence of capital and exchange controls in the weak-currency member countries (Wyplosz, 1986). This runs counter to German interest in European financial integration. Another weakness of the credibility hypothesis is the implicit assumption that the act of fixing the DM exchange rate carries more credibility than announcing an independently set monetary target. Yet, once private sector expectations are set in accordance with the exchange rate target and, hence, the German low-inflation standard, the high-inflation central bank has a strong incentive to break the target and choose a more inflationary policy to lower unemployment. This incentive must be offset by an additional cost to the central bank, if the exchange rate target and, therefore, the EMS is to be considered a credible arrangement. Several authors have argued that the additional source of discipline in the EMS is the political cost of breaking the arrangement. Melitz (1988), for example, suggests that a surprise exit out of the EMS would be regarded as breaking an international agreement and would be penalized by voters. In a related argument, Melitz (1988, p. 58) suggests that ‘under flexible rates, voters are likely to view exchange rates as determined essentially by the market, while in case of a political agreement about the exchange rate, they hold their political leaders responsible for devaluations. Devaluations cost votes.’ Thus, the disciplinary force of the EMS would rest in the loss of votes following either an exit out of the system or a realignment necessary to accommodate a deviation from Germany’s inflation standard. Yet, the importance of abstract international arrangements such as the EMS, or for that matter devaluations, in swinging national elections remains empirically unclear. To summarize, there are important questions left open in the credibility thesis underlying GDH. The German incentive for being in the system is ambiguous; so are the true credibility gains; and the required, exogenous source of discipline is not clearly identified. Next, we turn to an empirical test of GDH.

362

German II.

tlorninuncr

A test of German

in the E,LfS

dominance

in the EMS

Empirically, GDH seems to be based primarily on the reduction and convergence of inflation rates in the EMS since 1979. These data, compiled in Table 1, show that average inflation in the EMS peaked in 1980 at 11.6 per cent, and declined from then on steadily to reach 2.2 per cent in 1987. The standard deviation of inflation rates among the members fell from 6.2 per cent in 1980 to 1.9 per cent in 1987-prima facie evidence of convergence. Since the German inflation rate was always at the lower end of the group’s inflation rates, this evidence can be interpreted as showing that EMS inflation rates converged to the German rate. From this, supporters of GDH have concluded that the Bundesbank is the price leader of the system. On a closer look, however, the data are less convincing. The lower part of Table 1 reports the rates of inflation for a group of OECD countries outside the EMS during the same time period. 4 The inflation performance of this group during the 1970s was similar to that of the EMS (see Ungerer et al., 1986). Table 1 indicates that it was similar to the EMS during the 1980s too. Average inflation in the non-EMS group peaked in 1980, too, and declined subsequently to about 3 per cent in 1987. As in the EMS, the standard deviation of inflation rates declined during that time from 5.1 per cent to 2.1 per cent. Thus, convergence to the low ‘German’ rate is not unique to the EMS. Dornbusch (1989) and Fratianni and von Hagen (1990a) have recently pointed out that the cost of disinflation in the EMS countries has not been lower than in non-EMS countries. The data are consistent with, at least, two alternative interpretations. One is that both EMS and non-EMS countries have responded to common external shocks and constraints during the 1980s such as the tightening of US monetary policy and the decline in oil prices. The other is that policymakers, inside and outside the EMS, were generally disenchanted with the outcomes of the active demand management pursued during the 1970s and were willing to adopt more restrictive disinflationary policies (Chouraqui and Price, 1984). Both alternatives are observationally equivalent to GDH with respect to the inflation data in Table 1, in that both imply that inflation rates converge to the lower end. But neither one assigns any special role to the EMS in this process. This means that it is impossible to test GDH on the basis of EMS inflation rates.

II.A.

Model specificatiorl

In view of this observational equivalence, we propose to test GDH by focusing on monetary policy actions rather than on inflation rates, which reflect the results of such actions. European monetary policymakers commonly express and assess their actions in the short run in terms of the changes in short-term domestic money market rates such actions produce. That is, changes in money market rates summarize the short-run course ofmonetary policy. With this in mind, we base our test on a linear dynamic model of domestic (on-shore) money market rate movements in the seven EMS economies. The model can be interpreted as a system of central bank reaction functions. Due to obvious data limitations, we restrict ourselves to a minimal set-up of such a system. Our empirical model allows the change in the interest rate in EMS country i, Ari,

J~~RGEN VON HAGES AND i=

MICHELE

363

FRATIANNI

1,. . ., 7, to respond to the following set of explanatory

variables:

1. Own lags of Ari. 2. Measures of domestic inflation, 7ci, and domestic output growth, AJ’~. 3. US interest rate movements, Arust representing monetary policy in the rest of the world. 4. Interest rate movements in other EMS countries, Arj, j # i, j= 1, . . . ,7. All arguments in the second to fourth group may enter contemporaneously and with lags. The first two sets capture the basic own dynamics of monetary policy actions and their orientation at domestic policy goals. With Arus as an argument, the model gives room to reactions, in each EMS country, to monetary policies outside the system. The fourth set of variables is used to model the interactions of monetary policies in the EMS. Let AR be the vector of EMS interest rates (Ar,, . . ., Ar,)‘, AX the vector of domestic variables (rci, . . ., II,, Ayi, . . . , AJJ,)’ and Ea vector of serially uncorrelated residuals (E,, . . . , E,)’ with expectation E(si) = 0 and variance E($) = ~~~~We write the basic system as:

(1)

A,AR,

= d+ i

AjAR,_j+

i

BjAX,_j+

j=O

j=l

i

CjAr,,,l_j+s,.

j=O

Here, Aj, B,, and Cj are 7 x 7, 7 x 14, and 7 x 1 matrices and d is a fixed 7 x 1 intercept vector. We impose the following, identifying restrictions on equation (1) :5 (2)

i = 1,...,7;



no ii = 1)

(b)

E(E,E;) = diag(oii),

cc>

E(&,&i*)= 0,

Cd)

b.., = 0,

i=l

,..., 7,

i= 1,...,7; t # t*;

k=l,...,

14,

ifk,

k-7

(2a) is simply a natural normalization of the system. Conditions (2b) and (2~) put all interaction among EMS monetary policies in terms of the A-matrices. The test of GDH is, therefore, mainly concerned with their properties. Condition (2d) says that domestic inflation and output growth have direct effects only on the domestic interest rate in each country. Finally, we let Ar,, Arz, and Ar, denote the changes in the German, French, and Italian money market rates, respectively. We are now ready to derive the implications of GDH. GDH claims that the pattern of monetary policy interaction in the EMS is highly restrictive and hierarchical, and the scope for independent actions by EMS members other than Germany very limited. This basic proposition can be expressed by restricting the parameters of our system, making our hypothesis empirically distinct from alternative hypotheses of policy coordination in the EMS. German dominance of the EMS has four important aspects, each leading to a different set of restrictions. First, the other members do not react independently to monetary policies originating outside the EMS, after one controls for the German reaction to these policies. That is, all effects of Ar,, on the EMS must be transmitted through German reactions to them. This yields: Hl:

‘World insularity:’

c..~ = 0,

i= 2,...,7.

German dominance in the EMS

364

Rejecting Hl means that one cannot exclude that monetary policies in the EMS react to external constraints over and above what is implied by following Germany’s policy rule. Second, under GDH, EMS members other than Germany do not interact independently among each other: H2:

‘EMS insularity:’ u..,~ = 0,

i #j,

i,j= 2, . . . . 7.

Suppose H2 is rejected. In this case, the EMS is a system of interdependent monetary policies, where each country could react to the other members’ policies as well as to the German one. Consequently, Germany would be one among several equally constrained players in the EMS. Such an outcome does not exclude that Germany could be a very influential player. Next, monetary policies in the other member countries, i= 2, . . . ,7, must depend significantly on German policy and we must reject: H3:

‘Independence

from German policy:’ n,,,, = 0,

i = 2, . ...7.

Finally, GDH is only meaningful if the dominant country follows her own most preferred targets and strategies without regard to the wishes and pressures from other EMS members. Otherwise German policy would reflect the policy preferences in other countries and there would be no dominance. This yields: H4:

‘German policy independence:’

a., ii = 0,

i=2,...,7.

With the identifying restrictions (2), the four hypotheses Hl-H4 have an interpretation in terms of Granger causality. 6 GDH consists of the following causality structure: the US interest rate is not Granger causal for interest rates in the EMS other than (possibly) Germany’s, if Ar, is controlled for; monetary policy in a member country other than Germany does not Granger cause policies in any other EMS country, again if Ar, is controlled for; the German interest rate Granger causes interest rates in other EMS countries; and, finally, other EMS rates do not Granger cause the German interest rate. Altogether, GDH implies the joint validity of six causality (H3) and 42 non-causality (Hl, H2, and H4) relations for the EMS. Evidently, simple Granger causality of German monetary policy for the rest of the system alone, is a much weaker statement than German dominance, and showing that the German interest rate Granger causes EMS rates does not imply that GDH holds. The hypotheses Hl-H4 define a very stringent or ‘strong’version of GDH ruling out any short-run deviation of EMS policies from the path prescribed by the leader. A less restrictive, and for that matter a more plausible version of GDH, is that German monetary policy has a persistent effect on the EMS, while other effects are only temporary. To formulate this version, we define the operators Qt”.,ij)

=

i:

s=o

as,ij

and

Q(c.,lj) = i c,.i s=o

as the sum of all relevant coefficients. The values of g(a.,ij) and g(c..i) are proportional to the long-run impact of a change in country j’s interest rate and the US rate on country i’s rate. Evidently, g(a.sij)=O and g(c i)=O indicate that country j’s interest rate or the US rate have no lasting effect on& rate, even though restrictions u.,~~=O and c,.~=O may be violated. This definition leads us to

JCRGES VON HAGEN AND MICHELE FRATIANNI

formulate

365

the ‘weak’ version of GDH:

HlW:

‘Weak world insularity:’ gCc..i)

=

i=?

Ot

_)...)

7

‘Weak EMS insularity:’

H2W:

9Ca.,ij)

=

‘Weak independence

H3W:

S(a.,il

H4W:

‘Weak German

i#j, i,j = 2,...,7

O9

1 =

from German O?

policy:’

i = 2,...,7

policy independence:’

S(Q.,,il = 0,

i = 2,...,7.

Other members may deviate from the German rule by reacting to outside impulses and by interacting among one another, but these deviations vanish over time, while the reactions to German policy do not. While Germany would still determine the basic course of monetary policy in the EMS, the weak version of GDH allows for more short-run freedom of policymakers in the EMS.

II.B. Estimution Our empirical work uses monthly data from the IMF’s International Fincmciul Statistics tape. Interest rates are ‘money market rates,’ line 60b. Domestic output is measured as ‘industrial production,’ line 66..c and domestic inflation in terms of ‘consumer prices,’ line 64. With the exception of domestic output, all data are seasonally unadjusted. To reduce the number offree parameters in the system, we impose the additional restriction on the matrices A that: (3)

‘j’.,ij

=

‘ka.,ik~

i#k,j;

j,k=4

,...,

7;

i=l,...,

7,

where the coefftcients c(~are country j’s share in regional GNP (see Table 1). The group of countries 4, . . ., 7 consists of Belgium, the Netherlands, Ireland, and Denmark. Thus, condition (3) says that in the equations for Germany, France, and Italy, we use a weighted sum of the interest rates of those four countries. rather than each interest rate individually. In each of the equations for that group. we use weighted sums of the remaining three countries. The German, French, and Italian interest rates are all left unrestricted. Preliminary data inspection and testing revealed significant heteroskedasticity of interest rate changes if the sample is split after March 1983. To account for the reduction in variances, we use the adjustment factors H in Table 2. The Belgian and Danish equations are augmented by dummy variables so as to eliminate a few extreme observations. Finally, we define a 7 x 1 vector of dummy variables, D,, zero before March 1983 and one thereafter. All lagged regressors in the model and Ar,,,,.are multiplied by this dummy and the resulting terms are added to the model. In this way, we can allow and adjust for possible parameter changes at the sample break point. The choice of the break point is suggested by the fact that the March 1983 realignment marks the end of the ‘Mitterand experiment’ in France.

._

-

.

-

Australia

I

7.7 4.1 9.3 6.0

-

3.08. Austria

-

9.6 4.7 7.3 6.5

9.1 3.7 9.1 7.5 45.5 3.6 3.6 13.4 Il.3

8.5 4.4

4.5 9.6 10.7 4.1 13.2 14.8 4.2

1979

.-.,,

I .23.

Canada

12.4 5.1 10.9 7.7 9.1 4.1 8.7 6.2

9.7 6.8 12.4 12.0 50.6 4.9 6.5 11.9 10.4

11.2 4.6

Il.6 6.2

10.1 6.4 10.2 11.6 58.5 8.0 4.0 18.0 13.5

7.6 11.7 13.4 6.3 20.4 17.8 6.7

1981

6.6 12.3 13.8 5.4 18.2 21.2 6.5

1980

6.4 4.2 6.7 6.4

11.1 5.4 10.8 9.3 49.1 2.6 5.7 8.6 6.2

10.0 4.4

8.7 10.1 II.8 5.3 17.1 16.5 5.9

1982

._

--

-

-.

5.61, Finland 0.94, Grcccc 0.71, Japan 20.03, Switzerland

34.42, Ireland 0.99, Italy 21.07, Netherlands

1982 real GNP-based

3.8 2.7 3.6 4.6

6.7 3.2 4.0 5.9 32.0 2.0 3.4 6.1 3.6

4.9 2.7

4.9 4.7 5.8 2.2 5.4 9.2 2.2

1985

_

.

I

1.79, UK 8.98, USA 57.63.

7.22.

4.2 2.3 4.1 3.5

4.5 5.7 4.3 7.1 30.8 2.3 2.9 5.0 4.3

6.0 3.2

6.3 6.3 7.4 2.4 8.6 10.8 3.3

1984

with the following,

3.9 1.2 4.8 I I.0

10.1 3.3 5.8 8.4 86.1 1.8 3.0 4.6 3.2

7.9 4.4

7.1 6.9 9.6 3.3 10.5 14.7 2.8

1983

rates (per cent).

Averages and standard deviations are computed

7.0 3.7 6.2 9.9

1.9 3.6 9.0 7.8 44.1 3.8 1.1 8.3 7.6

5.9 5.3

4.5 10.1 9.1 2.7 7.6 12.1 4.2

1978

2.97, France 2X.84, Germany

b~rernc~fio~nl Fi~rtr~rcicrlSro/i.uics.

Belgium 4.55, Denmark

Non-EMS:

EMS:

Source: IMF,

Average Standard deviation Average without USA Standard deviation

Non-EMS Australia Austria Canada Finland Greece Japan Switzerland UK USA

12.3 5.5 8.0 12.7 30.5 8.0 1.3 15.8 6.5

8.8 4.9

Average Standard

deviation

7.1 11.1 9.4 3.7 13.6 17.0 6.5

EMS Belgium Denmark France Germany Ireland Italy Netherlands

1977

TAI~LBI. CPI inflation

3.2 2.1 2.7 3.6

8.6 1.4 4.4 4.1 16.4 0.0 I .4 4.2 3.6

2.2 I .9

1.5 4.0 3.3 0.2 3.1 4.7 0.0

1987

-.

weights (per cent).

2.3 2.3 2.7 3.5

8.7 1.7 4.1 2.9 23.0 0.6 0.7 3.4 2.0

2.6 1.7

1.3 3.6 2.5 -0.2 3.8 5.9 0.1

1986

3.5 1.8 2.9 2.6

1.2 1.9 4.0 5.1 13.5 0.7 1.9 4.9 4.0

2.5 1.4

1.2 4.6 2.7 1.2 2.2 4.7 0.8

1988

JORGEN VON HAGES

With the introduction (4)

A,AR,

AND

MICHELE FRATIASXI

of the shift parameters,

= d+d*ID,+

~ (Aj+AfID,)AR,_j+ j=I

367

the model is now: ~ (Bj+B*ID,)AX,_j j=O

n

+

C

(Cj+Cj*ZDt)Ar,,.f_j+&,,

j=O

where I is an identity matrix and the elements of d*, A*, B*, and C* are the differences in pre- and post-March 1983 parameter values. The model thus has two parameterizations: the pre-1983 parameter values are given by the matrices d, A, B, and C, the post-1983 values by the sums ofd and d*, A and A*, Band B*, and C and P. With these preliminaries, our empirical analysis proceeds as follows. In the first step, we estimate a ‘broad’ specification of the model, allowing for a maximum of three lags for all interest rates and lags one and two for each domestic price and output variable. We then reduce the specilication, eliminating lags and interactive dummy variables that do not contribute much to the explanatory power of the model. The criteria in this reduction process are that elimination of a term must not decrease the information value of the model, measured by Akaike’s AIC, nor lead to serial correlation of the residuals. The reduced specification is estimated using a 3SLS estimator. Table 2 gives a summary overview of the estimates. The negative AAIC values indicate that the reduction process increased the information value of the system. All regressions are highly significant. The statistic S is the F-test of joint significance of the interactive dummy terms retained in each equation. Only the French interest rate model does not change significantly over the sample period; the Italian equation contains the largest number of shifts. II.C.

Testing for German dominance

The tests of the hypotheses Hl-H4 in the strong and weak versions are conducted as F-tests, after imposing the relevant restrictions on the entire system. The hypotheses Hl-H3 and HlW-H3W are tested on two levels. First, we impose the restrictions ofeach hypothesis on individual equations, leaving the other equations of the system unrestricted. The results of these tests are reported under the country labels in the following tables. Second, we force the relevant restrictions on all six equations simultaneously. The results of this more stringent test are reported under the label ‘system.’ Testing the strong version of GDH leads to a clear rejection of the four hypotheses in almost all cases, for the system as a whole, and for both subperiods. We do not report these results but instead pay attention to the more differentiated-and hence more interesting-results of testing the weak version of GDH (see Tables 3a and 3b). This evidence is more favorable to GDH in several ways. In the tirst EMS period, ‘world insularity’ is rejected for Denmark and the Netherlands; ‘EMS insularity’ is rejected for Denmark, Ireland, and Italy; both hypotheses are rejected at the system level. ‘Independence from German policy’ cannot be rejected only for Belgium, Denmark, and Italy, whereas for the other countries Germany is a significantly influential player. However, ‘independence of German policy’ must be rejected.

0.33 0.33 1.oo 0.66 0.25 0.60 0.48

estim;ltcs.

up tolagsix.

l&tor

between

0.15 0.22 0.38 0.68 0.33 0.84 0.72

SE

S is the F-test for p;lrameter

srability;

numbers

with 6d.o.f.

2.

Summary

and 1983.3-88.4.

0.17 0.26 0.42 0.76 0.34 0.91 0.74

F

2.66** 5.37** 3.86** 5.41** 4.33** 3.58* 16.12**

d.0.f.;

denominalor

Multiplier

(5) (1) (9) (5) (5) (6) (7)

the second slep

tcsl for residual uutocorreh~tion ror the twospeci(ications,b:~sedon d.o.T. are 612.

AICcriteria

3.18** 1.90 2.98** 3.09** 6.23** 5.00** 5.62**

1.30 5.80 6.20 4.37 5.33 8.60 3.50

and from the second

S AR(6)

for the reduced specilication

- 23.5 -31.7 - 17.7 - 30.7 -43.3 -28.7 - 29.8

AAIC

AR(6) is the LnGr;lngc

Akaike’s

of parameters.

is thedifferencein

are numerator

under the Null.AAIC in parentheses

0.38 0.40 0.51 0.57 0.48 0.49 0.84

R2

of estimates.

F is the F-test ol model significance

nnd 108 less 1he number

1979-83.3

20 12 23 21 19 23 26

Reduced specification # Parameters SE

Degrees of freedom are the number olparamcters

adjustment

0.50 0.56 0.61 0.68 0.57 0.57 0.87

R2

AR(6) hasachi-squnredistribution

s1ageestimution.

NOW: If is the heteroskedasticity

Germany France Italy Belgium Netherlands Ireland Denmark

H

Broad specification

TABLE

23 gS’ 2 “, 3 2 2

Q

JCRGEN VOX HAGEN AND MICHELE FRATIANSI

TABLE

3a. Tests of weak German dominance interest rates, 1979.4-83.3). HI

Germany

-

Belgium

1.31

Denmark

10.24**

France

0.39

Ireland

0.91

Italy

0.34

Netherlands

4.81* (3) 3.36** (6)

System

H2

(monthly

H3

369

onshore

H4 3.08*

1.67 (3) 2.86, (3) 0.2 (1) .5.14** (3) 7.16** (2) 1.13 (3) 2.98** (15)

0.11

-

0.20

-

20.41**

-

3.82* 2.99 13.47**

-

6.77** (6)

-

Note: Hl refers to world insularity; HZ to EMS insularity; H3 to independence from German policy; H4 to German policy independence. Entries are values of the F-tests based on 3SLS estimates. Numbers in parentheses are,numerator degrees of freedom. Denominator degrees of freedom are 612 for all tests. * and ** denote signiticance at the 5 and 1 per cent levels, respectively.

TABLE

3b. Test of weak German dominance interest rates, 1983.4-88.4). Hl

H2

(monthly

H3 -

Germany Belgium

1.31

Denmark

0.59

France

0.74

Ireland

1.53

Italy

6.51**

Netherlands

1.23

System

2.06 (6)

2.33 (3) 2.61* (3) 0.20 (1) 4.89** (3) 8.61** (2) 1.52 (3) 3.32** (15)

onshore

H4 3.03*

5.47% 1.10

-

20.40** 0.63

-

0.12

-

13.47** 7.00** (6)

Nore: HI refers to world insularity; HZ to EMS insularity; H3 to independence from German policy; H4 to German policy independence. Entries are values of the F-tests based on 3SLS estimates. Numbers in parentheses are numerator degrees of freedom. Denominator degrees of freedom are 612 for all tests. * and ** denote significance at the 5 and 1 per cent levels, respectively.

370

Gernun

rlotnitm~cr in [he EMS

In the post-March 1983 period, ‘independence from German policy’ is clearly rejected for Belgium, France, and the Netherlands. For the same countries, we do not reject ‘EMS insularity.’ ‘World insularity’ is rejected only for Italy, but cannot be rejected at the system level. German interest rates still react significantly to interest rate changes elsewhere in the EMS in this subperiod. The characterization of the EMS policy game emerging from these results is as follows. Overall, monetary policy in the EMS is interactive. Germany is a significant player, but so are other central banks, particularly the French and the Italian. The strictly hierarchical structure suggested by GDH is not confirmed by the data. Furthermore, particularly after March 1983, almost all EMS members show no lasting reactions to policies outside the system that might cause divergent interest rate movements. If nothing else mattered, there would be justification in viewing the EMS as an asymmetric arrangement, with German leadership preventing other countries from reacting independently to the rest of the world. However, the rejections of German independence and EMS insularity for some countries indicate the limits of this interpretation. In sum, the evidence on national interest rates is consistent with the long-run evidence for monetary base growth in the EMS we have presented in Fratianni and von Hagen (1990b). III. Asymmetries

in the EMS-a

quantitative

assessment

A more lenient way to assess asymmetry and German dominance in the EMS is to consider the estimated interest rate responses in the EMS to interest rate innovations (E,) in the various member countries. For this purpose, we use the parameter estimates obtained for the system to compute the impulse response functions l+,(k), which specify the current change in countryj’s interest rate due to an autonomous, unit-size, positive change in i’s interest rate k periods ago.’ The total effect on the level of countryj’s interest rate is then given by the cumulative change in rj over the k periods: (5)

Hii

= i

hii(

n=O

Table 4 reports the estimated values of HIi and Hj,(k), j= 2, . . ., 7, for lags k = 0, 1, and 6. The first column specifies the response of other members to a unit increase in the German interest rate, while the second column gives the German response to an increase in other members’ rates. All responses are positive. In most cases, other members’ responses to Germany increase over the six-month period. During the first period, the French and Italian interest rate reactions reach unity after six months, while the reactions of the other countries remain lower. In contrast, German responses to other countries remain constant over time or decline after the first month except in the case of the Netherlands. The German response to Italian interest rate innovations vanishes after six months. The picture changes in the second period. The German impact on France and Italy falls. At the same time, the German reaction to French interest rate innovations declines over time, but the reaction to Belgium, Italy, and the Netherlands increases over time.’ The interest rate responses of Table 4 suggest two interpretations of the EMS. On the one hand, Germany is a ‘relatively strong’ player in the system in the sense that other countries react more strongly to her policy than vice versa. This form of

JCRGEU

TABLE 4.

vos

HAGES

AND MKTHELE

371

FRATI.AS.NI

Responses to unit interest rate innovations Lag 0 H,j Hj,

1979-83.3 Lag I H,j Hj,

France Italy

0.29 0.28

0.36 0.39

0.56 0.57

0.30 0.02

1.06

0.38

1.11

Belgium Netherlands Ireland Denmark

0.09 0.26 0.31 0.03

0.16 0.30 0.03 0.09

0.16 0.28 0.27 0.09

0.12 0.21 0.03 0.06

0.34 0.56 0.25 0.27

0.00 0.20 0.41 0.05 0.10

Lag 0 H,j Hj,

1953.4-88.4 Lag I H,j Hj,

H,j

Hj,

0.25 0.29 0.09 0.26 0.30 0.03

0.58 0.43 0.75 0.22 0.18 0.35

0.75 0.23 0.68 0.53 0.23 0.36

0.08 0.51 0.21 0.55 0.07 0.09

France Italy Belgium Netherlands Ireland Denmark

0.36 0.39 0.16 0.30 0.03 0.09

A’OIP: H,, denotes the response to a German innovation the German response to an innovation in country j.

0.17 0.70 0.22 0.40 0.04 0.1 I

Lag 6 H,j

Hi,

Lag 6

in country

j. fIj, denotes

dominance may, however, reflect the sheer relative size of the German financial markets in the EMS and cannot be equated with GDH. On the other hand, France and Italy appear to be ‘relatively weak’ players-especially during the first EMS period-in that they adjust more fully to German policies than other EMS members, while their policies have less of an impact on German policy. In this sense, the French position remains relatively weak and the Italian position improves in the second EMS period. The evidence of Table 4 provides some justification for the dissatisfaction French and Italian officials have expressed about Germany counting too much in the EMS. Using the currency weights IL’~of the ECU, we construct an average money market rate for the EMS,

i=l

specifying the return of an ECU portfolio invested in the seven money markets.’ The effect of a unit innovation in countryj’s interest rate k lags ago on the average EMS rate can be obtained as the weighted sum of its effects on the individual rates,

372

Gernxm

dominance

in he

E.Cf.7

The total change in REMS due to unit shocks originating in all EMS countries then is ;

i

j=l

!=I

WiHji(k).

Thus, all other things the same, we compute the relative contribution of an innovation in an individual rate, Rj, to a change in the average EMS rate as:

Expression (6) is a proximate measure of country j’s relative importance in the EMS. Empirical estimates of this measure for lags k = 0, 1, and 6 are shown on the right side of Table 5. Germany’s contribution is clearly the largest in both periods. During the first period, the French and Italian contributions at lag six correspond to their relative weights in the ECU. In contrast, the French contribution is much smaller than the French weight would lead to expect in the second period, while the Italian and the Dutch contributions are larger. These observations confirm the results of Table 4, namely that Germany is a ‘relatively strong’ player while France and Italy are ‘relatively weak’ players in the EMS, France the more so in the second period. All other things the same, changes in each money market rate i in the EMS are the result of current or lagged innovations in this and all other rates in the system,

j=l

Consequently, measured as:

the relative

(7)

z Hji(k)l[

importance

i

Hjr(kl]

of the EMS for each country

= I-Hii(kl/

[i

can be

Hji(k)l,

which specifies the relative contribution of interest rate innovations in all other EMS countries k lags ago to changes in country i’s rate. The closer to zero is this TABLE 5. Decomposition

Lag

Relative contribution of domestic rate to changes in EMS rate G F I B NL Ire Dk

of interest rate changes. Relative contribution of EMS member rates to changes in domestic rate NL Ire Dk G F I B

0 1 6

0.31 0.35 0.41

0.21 0.25 0.20

0.18 0.10 0.08

0.10 0.09 0.09

0.16 0.15 0.17

1979.3-83.3 0.02 0.04 0.53 0.02 0.04 0.40 0.02 0.04 0.40

0.32 0.40 0.56

0.46 0.57 0.64

0.35 0.45 0.58

0.35 0.33 0.53

0.60 0.17 0.38 0.58 0.58 0.68

1 6

0.28 0.32

0.17 0.10

0.24 0.20

0.10 0.09

0.16 0.23

1983.4-88.4 0.02 0.04 0.57 0.03 0.03 0.56

0.47 0.61

0.49 0.51

0.68 0.70

0.31 0.47

0.58 0.71 0.53 0.64

Note: G =Germany, Dk = Denmark.

F= France,

I = Italy,

B= Belgium,

NL = Netherlands,

Ire= Ireland,

and

JCRGEN VON HAGEN

AND

MKHELE FRATIANNI

373

measure, the more independent is country i in the EMS; the closer to one, the less independent is it. The left-hand side of Table 5 reports the estimates of (7). For Belgium, Denmark, France, Italy, and the Netherlands this measure increases with the length of the lag. In contrast, for Germany it decreases or remains the same. Before 1983, Germany’s measure at lag six is the smallest of all EMS countries, meaning that the Bundesbank, more than any other EMS central bank, was able to pursue a relatively independent policy. However, a relatively high degree of independence of German monetary policy is not equivalent to German dominance in the EMS. In contrast, Germany’s measure is much more in line with the other countries after 1983. This suggests that the Bundesbank has lost much of her relative independence in the EMS since 1983. IV. Conclusions We have presented an empirical analysis of German dominance in the EMS, based on national money market rates. The latter are the primary operating targets of central bank policies in the EMS countries. Hence our analysis has focused on short-term central bank actions. We have formulated and estimated a model of interest rate movements in the EMS and have derived the restrictions implied by the hypothesis of German dominance. The strict form of the German dominance hypothesis was clearly rejected. The only aspect of the EMS consistent with German dominance is the members’ conformity of policy responses to monetary policies originating outside the EMS since 1983. In the short run, the EMS is best portrayed as an interactive web of monetary policies, where Germany is an important player, but not the dominating one. This result raises an obvious question: through what mechanism can EMS members disanchor their policies from the relatively restrictive course of the Bundesbank? There are two ‘safety valves’ in the EMS. First, capital controls and exchange controls shelter domestic from international financial markets. These controls manifest themselves in differentials between offshore and onshore interest rates and provide monetary policy independence in the short run (Giavazzi and Pagano, 1985). Second, the possibility of parity realignments in the EMS ensures that each member has the freedom to choose its own, most preferred long-run monetary trend (Wyplosz, 1988). These ‘safety valves’ reflect the principle of flexibility stressed in the original design of the EMS. Our model estimates form the basis for a quantitative assessment of dominance and asymmetries in the EMS. We find that Germany’s policy is not independent from other members’ policies in the EMS. In this sense, Germany is not dominating the system. However, other countries react more strongly to German policies than vice versa. Before 1983, the Bundesbank was the least dependent central bank in the system; after 1983 this relative independence has diminished. One remarkable asymmetry in the EMS is the relatively weak position of France in the policy game. Particularly after the end of the socialist ‘Mitterand experiment’ in 1983, French monetary policy seems to have reacted to monetary policy actions in Germany and other EMS countries more than other countries have reacted to French actions. It is tempting to conclude that many observers have mistaken German dominance with the relative strength of Germany and the relative weakness of France in the EMS.

373

Gernum dominance in the E.LIS

Notes 1. For a review of the early debate over the EMS see Fratianni

and von Hagen (l99Oa). The general point here. that policy coordination among central banks may make all parties worse off, has been made by Rogoff (1985). 3. The Finance Ministers of the EMS modified the rules governing interventions in September 1987. In contrast to the Bundesbank, the Banque de France has interpreted the modifications as saying that intramarginal interventions are now equally compulsory. 4. We treat the UK as a non-member of the EMS, as she does not participate in the exchange rate mechanism. 5. To simplify notation, we use a,.ij to specify restrictions on each element of the sets (~l,,~~). s=o, 1,. ., and similarly for b,,ij and c,.~~.Thus, a,,jj=O means that the (ij)th coeflicient of matrices A at all lags is zero. 6. In the context of our empirical model, &anger causality should be understood as including instantaneous causality, as the off-diagonal elements of the matrix A, do not require lags in the leading terms. 7. Note that the German reaction to a Dutch interest rate innovation is of the same order of magnitude as the Dutch response to a German innovation. This result is consistent with De Grauwe’s (1988) observations of interest rate links between Germany and the Netherlands. 8. The ECU weights used here are 0.395 for Germany, 0.221 for France, 0.1 I for Italy, 0.104 for Belgium, 0.125 for the Netherlands, 0.013 for Ireland and 0.032 for Denmark. These weights are as of April 1988, excluding the pound sterling and the drachma. 2.

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