The relationship between interest rate differentials and macroeconomic variables: a panel data study for European countries

Based on panel data regressions the relationship between 12 month interest rate differentials and macroeconomic variables is analyzed for nine Europea n countries relative to Germany. Stationarity properties of the variables a re examined by tests developed for panel data models. The distribution of t he test statistic is not normal and is bootstrapped from the sample at hand . All significant regression coefficients are estimated with the predicted sign. In particular, the inflation differential, the real income growth dif ferential, relative labor costs, and the current account have a strong effe ct on the interest rate differential. Hence the results indicate that gover nments have some scope for influencing the interest rate differential by co nducting the appropriate macroeconomic policy. These results are considerab ly more optimistic compared to earlier studies, where interest rate differe ntials are frequently measured at 1 month and 3 months maturity. Included a lso is an analysis of whether the ERM countries have gained more credibilit y in exchange rate policy through the exchange rate system. (C) 2000 Elsevi er Science Ltd. All rights reserved. JEL classification: C23; E43; F33.