What Might Central Banks Lose or Gain in Case of Euro Adoption - A GARCH Analysis of Money Market Rates for Sweden, Denmark and the UK

Abstract:     
This study deals with the question whether the central banks of Sweden, Denmark and the UK can really influence short-term money markets and thus, would lose this influence in case of Euro adoption. We use a GARCH-M-GED model with daily money market rates. The model reveals the co-movement between the Euribor and the short-term interest rates in these three countries. A high degree of co-movement might be seen as an argument for a weak impact of the central bank on its money markets. But this argument might only hold for tranquil times. Our approach reveals, in addition, whether there is a specific reaction of the money markets in turbulent times. Our finding is that the policy of the European Central Bank (ECB) has indeed a significant impact on the three money market rates, and there is no specific benefit for these countries to stay outside the Euro area. However, the GARCH-M-GED model further reveals risk divergence and unstable volatilities of risk in the case of adverse monetary shocks to the economy for Sweden and Denmark, compared to the Euro area. We conclude that the danger of adverse monetary developments cannot be addressed by a common monetary policy for these both countries, and this can be seen as an argument to stay outside the Euro area.

Number of Pages in PDF File: 20

Keywords: Euro adoption, EMU, money markets, interest rates, GARCH models, international financial markets

JEL Classification: E42, E43, F36, G01, G15

working papers series