Mr. Wicksell and the global economy: What drives real interest rates?

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W i c k s e l l a n d t h e g l o b a l
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W h a t d r i v e s r e a l
i n t e r e s t r a t e s ?
M i c h a l B r z o z a - B r z e z i n a , J e s u s C r e s p o C u a r e s m a
S t a b i l i t y a n d S e c u r i t y.

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Editorial



This paper uses a Bayesian dynamic latent factor model to extract world, regional and
country factors of real interest rate series for 22 OECD economies. The authors find
that the world factor plays a privileged role in explaining the variance of real rates for
most countries in the sample, and accounts for the steady decrease in interest rates in
the last decades. Moreover, the relative contribution of the world factor is rising over
time. The authors also find relevant differences between the group of countries that
follow fixed exchange rate strategies and those with flexible regimes.


January 29, 2008

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Mr. Wicksell and the global economy:
What drives real interest rates?∗
Michal Brzoza-Brzezina†
Jesus Crespo Cuaresma‡
Abstract
We use a Bayesian dynamic latent factor model to extract world, regional
and country factors of real interest rate series for 22 OECD economies. We find
that the world factor plays a privileged role in explaining the variance of real
rates for most countries in the sample, and accounts for the steady decrease
in interest rates in the last decades. Moreover, the relative contribution of the
world factor is rising over time. We also find relevant differences between the
group of countries that follow fixed exchange rate strategies and those with
flexible regimes.
Keywords: Real interest rates, natural rate of interest, Bayesian dynamic
factor models.
JEL Classifications: E43, C11, E58
∗We would like to thank an anonymous referee and the participants in seminars at the Oester-
reichische Nationalbank, National Bank of Poland and Swiss National Bank for helpful comments.
We would also like to thank Grzegorz Saletra for obtaining part of the data. Any opinion expressed
are those of the authors and not necessarily of the represented institutions. The study was written
while Michal Brzoza-Brzezina was visiting the Oesterreichische Nationalbank.
†National Bank of Poland and Warsaw School of Economics.
‡Corresponding author. Department of Economics, University of Innsbruck. Universit¨atstrasse
15, 6020 Innsbruck (Austria). E-mail address: jesus.crespo-cuaresma@uibk.ac.at

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1
Introduction
In this study we examine the nature of the determinants of short-term real interest
rates in open economies. To what extent do domestic conditions matter and to what
extent are international factors responsible for the behaviour of interest rates? Does
the ongoing process of globalization, characterized in particular by increased capital
mobility, change the relative role of domestic and international forces? What is the
role of regional exchange rate arrangements? Does the size of the economy matter?
How far are we today from the traditional approach to real interest rate determina-
tion laid down over a hundred years ago by Knut Wicksell?1 These questions appear
important both for theory and policymaking.
From the theoretical perspective, we still miss a satisfactory theory of interest rate
determination in open economies. The literature on microfounded open economy
models2 has advanced substantially over the recent years, so that current models
have standard features of the New Keynesian literature like monopolistic competi-
tion and nominal rigidities as well as specific open economy factors like home bias
in consumption. Nevertheless contemporaneous open economy models still seem
far from ready to analyze such detailed issues as capital flows and impediments to
international interest rate equalization as important determinants of interest rates.
Although our paper is not a direct contribution to this stream of theoretical litera-
ture, our results can be used as an input for the construction of models that aim at
explaining the behaviour of real interest rates in open economies.
From the policy perspective, the question of whether interest rates are determined
by domestic fundamentals or foreign factors seems important as well. In particular
in small economies with floating exchange rates it contributes to the discussion of
how “independent” monetary policy really is. However, the increasing role of world
1The Swedish economist Knut Wicksell (1851-1926) presented a theory of real interest rate
determination that still shapes the way most economists think about interest rates. According to
Wicksell (1898, 1907) the real rate of interest fluctuates around an unobservable equilibrium level
called natural rate of interest. The natural rate equilibrates ex ante savings and investment and
equals the marginal product of capital (in a closed economy setting). If the real rate equals the
natural rate, prices are stable, if it goes above (below), the economy contracts (expands) and prices
fall (rise).
2This literature started with the pathbreaking study of Obsfeld and Rogoff (1995). Recent
contributions include Clarida et al (2002), Gali and Monacelli (2005), McCallum and Nelson (2000)
and Faia and Monacelli (2006).
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factors in shaping yield curves and the resulting implications for monetary policy are
taken into consideration even by big central banks like the ECB (2007) or the FED
(Humpage (2005)). Our contribution quantifies the relative importance of domestic
developments (like loosening of the fiscal stance) versus international developments
in determining domestic monetary conditions.
Although the literature shows that international forces play a significant role in
determining real interest rates in open economies, most empirical contributions do
not explicitly quantify the relative strength of international, regional and country-
specific factors in the dynamics of the real interest rate. Our study aims at filling
this gap. For the first time in this application we use a dynamic factor model3,
which allows us estimating the changing role of world and EMU factors in shaping
real short-term interest rates. The factor model approach allows us using a much
wider set of explanatory variables than it was the case in most previous studies. Our
results are based on a sample of 22 OECD countries over the period 1983-2005 and a
wide range of variables that can potentially explain short and long-term movements
of real interest rates. We find convincing evidence for an important role of inter-
national factors in shaping real interest rates in open economies. In particular the
world factor explains almost 48% of the variance of the real short-term interest rate.
Moreover world developments lead to a decline of real rates of about 4 percentage
points over the period 1983-2005. In our view the low short-term variability of the
world factor shows that it describes movements of the underlying natural rate of
interest rather than common cyclical developments. We also find an important role
for an EMU factor (loaded for EMU members plus Iceland and Denmark). This fac-
tor leads to a hike in real interest rates in the 1980’s, peaks during the EMS crisis in
1992 and falls somewhat since then. Nevertheless, domestic developments (country
factors and idiosyncratic components) still play an important role in shaping real
interest rates, especially in economies with floating exchange rates.
A variance decomposition exercise in a rolling time window shows a substantial in-
crease of the variance share of the world factor until the mid 1990’s, which probably
reflects the steady progress of capital flows liberalization in the OECD countries in
the 1980’s and early 1990’s. The behaviour of the variance share of the EMU factor
3Dynamic factor models have been recently used in applications that, as ours, investigate the
relative role of domestic and international developments. Kose et al. (2003) extract world, regional
and domestic factors to test for the presence of a world business cycle. Mumtaz and Surico (2006)
use a similar model to investigate inflation developments in small, open economies.
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shows a decreasing importance through time. We find some evidence that the EMU
factor mattered more for poor EMS/ EMU members, which shows its importance
for cohesion countries. Finally, we aim at verifying the hypothesis whether the role
of the world factor is smaller for large economies. Our results give only very limited
support for this claim. We find some evidence of a negative relationship between
size of the economy and the proportion of the variance of real rates explained by the
world factor only in a very small subsample of countries that had liberalized capital
flows since 1983.
Our paper is structured as follows. Section 2 briefly reviews the related liteature
on the determinants of real interest rates in open economies. Section 3 explains the
econometric details of our dynamic factor model and presents the data used. In
section 4 we show the empirical results and conclusions are given in section 5.
2
Related literature
The issue of interest rate determination has been taken up in the empirical literature
frequently. While most studies concentrate on the role of fiscal developments in the
determination of real interest rates, here we concentrate on the part of the literature
which explicitly deals with the issue of domestic and international determinants of
interest rates. An important contribution from the early literature is Blanchard et
al. (1984). The authors seek to explain the high levels of real interest rates in the US
in the late 1970’s and early 1980’s. They note that interest rates are substantially
determined worldwide and explain US interest rates with international factors (tight
monetary policies and increased productivity). Another important contribution by
Barro and Sala-i-Martin (1990) deals explicitly with the world real interest rate. Ag-
gregate data of ten OECD economies are considered as a proxy to the world economy
and the role of shocks to desired saving and investment demand is estimated. The
results point at a significant role of monetary policy as well as stock returns (proxy
for profitability of investment) and oil prices (proxy for desired national savings) in
driving world real interest rates. The authors also find that world variables play a
dominant role in determining domestic real interest rates. Ford and Laxton (1995)
estimate a model for nine OECD countries, where individual real interest rates are
regressed on a set of country specific variables and aggregate net public debt-GDP
ratio. The authors conclude that the increase of world public debt-GDP ratio sub-
stantially boosts real interest rates. At the same time own country debt variables
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are in most cases insignificant. Orr et al (1995) estimate a panel cointegration model
for 17 OECD countries. The coefficients in the long-term (cointegrating) equation
show a significant impact of domestic variables (e.g. government deficit, current
account balance) as well as of the foreign (G3) real rate. The significance of the
latter for many countries is interpreted as showing the impact of international fac-
tors on domestic interest rates. Christiansen and Piggot (1997) show that long-term
interest rates in ten OECD economies are, to some degree, affected by foreign inter-
est rates. Moreover, the evidence from estimating their models in two subsamples
shows that the role of foreign factors increased somewhat over time. Nevertheless,
domestic economic fundamentals are found to be key factors shaping movements in
long-term interest rates among the countries with floating exchange rates. Spillovers
between interest rates between the US and euro area are documented by Chinn and
Frankel (2003). They also confirm and important role of domestic fiscal variables
on interest rates, but fail to prove the significance of foreign developments. Finally,
Desroches and Francis (2006), use a similar methodology to Barro and Sala-i-Martin
(1990) and confirm a significant impact of several factors (e.g. labour force growth,
economic liberalization, demographic structure and goverment deficits) on savings
and investment and, as a consequence, on the world real interest rate.
Another stream of relevant literature relates to testing the real interest rate parity
hypothesis. In brief, the hypothesis states that in absence of restrictions to goods
and capital flows, real interest rates should converge internationally. Most recent
studies (e.g. Chinn and Frankel (1995), Gagnon and Unferth (1995), Ong et al.
(1999), Goodwin and Grennes (1994) and Manusco et al. (2003)) find some support
for real interest convergence, especially if endogenous structural breaks are allowed
for. These studies, however, are based exclusively on interest rate data and ignore
fundamental determinants of real interest rates.
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