International convergence of short-term and long-term interest rates: Theory and empirical tests

A paper provides a theoretical model that illustrates how short-term and long interest rates would behave in perfectly integrated international financial markets. Using the cash-in-advance model of Lucas (1982), the paper obtains closed-form solutions for the term structure of interest rates in a 2-country framework. The results show that short-term rates need not converge unless the 2 countries coordinate their monetary policies. Short-term rates will be different due to differences in the stochastic and the deterministic components of growth rates in GDP and money supplies. On the other hand, long-term rates tend to converge and their difference will be due to differences in the deterministic parts of the money supply growth rates. These theoretical results are empirically tested. The results indicate that over the past 15 years, long-term rates have become closely linked, while short-term rates do not display a similar behavior.