Long- and Short-Term Interest Rates in 19

Countries: Tests of Cointegration and

Parameter Instability
A. C. ARIZE,* J. MALINDRETOS,** AND Z. IKE OBI***

Abstract
This paper examines the long-run relationship between short-term and long-term in-
terest rates (both nominal and real) in 19 countries, and explores the possibility that
the relationship is statistically stable using Lc, MeanF, and SupF statistics suggested by
Hansen [1992]. Empirical results obtained from various cointegration techniques (Jo-
hansen, Phillips and Hansen, Stock and Watson, and Park) and quarterly data (1973-
1998) show considerable support for the expectations hypothesis in all countries (except
the United Kingdom). In a majority of cases, it is also found that a stable relationship
exists between the short-te~n and long-term interest rates. (JEL E43)

Introduction
This paper formally tests whether short- and long-term interest rates of 19 countries are
statistically cointegrated. The single-country studies of Stock and Watson [1988], MacDonald
and Speight [1988], McFadyen, Pickerill and Devaney [1991], Hall et al. [1992], Wallace and
Warner [1993], and Mandeno and Giles [1995], among others, provide evidence in support
of a long-run relationship between the short- and long-term interest rates. Such evidence
appears to collaborate the expectations theory of the term structure of interest rates, which
argues that these two variables will not deviate from each other in the long-run, but wilt
move closely together. This is so because the theory views long-term rates as an average of
the expected short-term rates.
Studies such as Mustafa and Rahman [1995] and Taylor [1992] provide evidence in support
of the segmented-market theory, which is at the opposite end of the spectrum from the
expectations theory. Unlike the expectations theory, the segmented-market theory of the
term structure argues that short- and long-term rates are completely unrelated, because
they are determined independently of one another by market forces. Empirical evidence in
Mustafa and Rahman [1995] focused on the Engle and Granger (E-G) [1987] method and
data for the United States, whereas Taylor's [1992] study employed a unit-root test of the
short-long spreadseries and the VAR method, including the data for the United Kingdom.
In summary, the above discussions suggest that there is conflicting evidence in the lit-
erature on the relationship between short- and long-term rates. 1 No consistent conclusions
emerge from these studies. Nevertheless, which hypothesis prevails can have an effect on the
*Texas A&M University--U.S.A., **Yeshiva University--U.S.A, and ***City of Irving, Texas--
U.S.A. The authors would like to thank Don English, Keith McFarland, and Harold Langford for
helpful comments on earlier drafts. Special thanks to Kathleen Smith for excellent research assis-
tance. This research in funded by a GSRF-TAMU-C grant.

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model builder and on the conduct of monetary policy. Many macroeconomic models typically
employ a single interest rate in representations of the economy and decision making without
relying on a spectrum of differing maturities. Of course, if the expectations theory prevails,
then central banks can influence long rates by operating at the short end of the market.
The contribution of this study to the literature is the extension of the analysis to 19
countries, including the United States, using recent advances in time-series econometrics.
Despite the expansion in research on the linkage between short- and long-term interest rates
over the past few years, it has been limited mostly to the data for the United States and the
United Kingdom. The question of the nature of the linkage in other countries has not been
adequately examined in the literature. This study reports results for cointegration between
long-term and short-term interest rates in 19 countries. As Hall, Anderson, and Granger
[1992] point out, there are only a few empirical studies employing the cointegration method
in the term structure literature.
Another issue, however, that has not received any attention in this literature relates to
the stability of the cointegrating relationship. Previous studies investigating this linkage
have presumed (either explicitly or implicitly) that the relationship is stable. It is possible
that this may not be the case. There is no reason to believe a p r i o r i that, over the past 24
years, the relative importance of factors influencing the linkage between short- and long-term
interest rates has remained unchanged. As Hansen [1992] points out:

"One potential problem with time series regression models is that the estimated
parameters may change over time. A form of model mis-specification, parameter
non-constancy, may have severe consequences on inference if left undetected."

It is believed that credible evidence of such a linkage should be ascertained, not only by
testing for statistical cointegration, but also by investigating whether the cointegrating rela-
tionship has been structurally stable over the sample period. Therefore, the second objective
of this note is to provide new evidence on the stability of the cointegrating relationship be-
tween short - and long-term interest rates. For this purpose, tests for parameter instability
suggested by Hansen [1992] are employed. The relationship in both nominal and real terms
along the lines suggested in Mustafa and Rahman [1995] is also examined.
The analysis differs from previous studies in four novel perspectives. First, this study
avoids using pooled data of both the fixed and the floating exchange era by concentrating on
the quarterly period t973:2 through 1998:1 (t00 observations). 2
The countries examined in the analysis include Canada, France, Germany, Italy, Japan,
the United Kingdom, the United States, Austria, Belgium, Denmark, Ireland, the Nether-
lands, Norway, Spain, Australia, New Zealand, Korea, South Africa, and Thailand. The
sample includes OECD and developing economies. This diversity makes the sample reason-
ably representative, and the results of the study can at least be suggestive of some general
conclusions regarding other countries that have largely been ignored in the literature and
provide a basis to which future studies can be compared. The results may also provide a
valid comparison to the single-country studies, such as Mustafa and Rahman [1995], Wallace
and Warner [1993], and Taylor [1992].
Secondly, unlike previous studies, the authors test for cointegration using the multivariate
cointegration technique developed in Johansen [1995], which is a Full Information Maximum
Likelihood (FIML) estimator. Such an FIML estimator takes into account information on
the dynamic structure of the model and it also estimates the entire space of the long-run
relationships among a set of variables, without imposing a normalization on the dependent
variable a p r i o r i [Arize, 1996]. While most of the advantages of the Johansen approach
are primarily realized in multivariate models, Enders [1995] presents arguments favoring the