On real interest rate convergence among G7 countries

I analyze real interest rate convergence among six industrialized countries in 1975M1-2011M3 within a multi-country framework by means of a dynamic latent factor model. This approach makes it possible to examine common trending behavior and common transitory movements in the real interest rates. Time-varying variances of the components allow for gradual endogenous transition from a high variance regime toward a low variance regime. The estimation results suggest that four permanent and four transitory components capture the real interest rate dynamics among the sample of G7 countries at the beginning of the sample period. The common components' variances mostly decline over time, and in part even converge to values close to zero. This indicates a reduction in the number of stochastic factors, which in turn can be interpreted as confirmation of the convergence hypothesis of less cross-country dispersion over time. I observe rapid convergence during the late 1970s and 1980s, followed by slower transition since the beginning of the 1990s when financial markets had already been highly integrated.