International Finance Discussion Papers

EMS Interest Rate Differentials and Fiscal Policy: A Model with An Empirical Application to Italy R. Sean Craig 1991-405  (August 1991)

Abstract:  This paper develops a model showing how EMS interest rate differentials are influenced by fiscal policy. For countries like Italy, with large budget deficits, the commitment to a stable EMS exchange rate can entail costly fiscal adjustment. If the government believes these costs to be excessive, it may choose to adopt a more inflationary monetary policy and realign periodically. It is this possibility that the policy of targeting the stable exchange rate will be abandoned in favor of one with periodic EMS realignments that contributes to the interest differential.

Estimation of the model indicates that fiscal variables explain part of the Italian-German interest differential, and co-integration tests reveal that this relationship holds over the long-run. These results imply that the Italian-German interest differential is likely to persist in the second stage of European Monetary Union (EMU) if Italy fails to reduce its budget deficit, providing support for the view that fiscal convergence is a necessary element of EMU.

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