Domestic and external factors in interest rate determination

This paper develops a theoretical framework which allows for both domestic and external factors in the determination of interest rates. We argue that if capital controls are imposed, or if the risk premium is a function of disequilibria in the money market, domestic factors should also play a role. We assess empirically the role of both domestic monetary conditions and open economy factors in the US, Japan and Germany, France and Switzerland. Our results suggest the following. Concerning external factors, monetary policy in Germany affects significantly both US and Japanese interest rates; Germany, on the other hand, is rather responsive to developments in continental Europe, in spite of its ‘dominance’ of the EMS. As for domestic influences, inflationary expectations are an important factor in explaining interest rate behaviour in Japan, and the budget deficit plays a role in the US. Also, the US monetary authorities adopt a more accommodating policy than the Bundesbank.