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Money Markets and Politics

A Study of European Financial Integration and Monetary Policy Options

Jens Forssbæck and Lars Oxelheim

The dramatic evolution of financial markets in the 1980s and 1990s, accompanied by increasing institutional integration between nations (most notably in the EU), have fostered a widespread belief that governments – particularly those of small economies – have essentially lost the power to pursue sovereign, independent economic policies. At the same time, it is widely assumed that the loss of monetary-policy control is a major opportunity cost for a country adopting a rigid exchange-rate regime or, in the European context, for countries joining the EMU This book sheds light on these arguments.
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Chapter 6: Measuring Capital Mobility: The Degree of Direct Money Market Integration

Jens Forssbæck and Lars Oxelheim


The dramatic increase in capital flows across borders, coupled with the continuous dismantling of capital controls and regulatory measures in most parts of the world, are often taken as evidence that the world’s financial markets have turned into a single, global one. However, strictly speaking, the size of capital flows is a measure of activity – not of integration. It does not tell us the extent to which the financial markets of the world are truly integrated. As mentioned in Chapter 1, we see the capital mobility component of the ‘inconsistent trinity’ framework rather as the potential for capital flows, a concept closely linked to that of financial integration. We advocated the use of the ‘law of one price’ approach to measure how integrated markets really are – in other words, measuring the degree to which the price mechanism works to equalize riskadjusted returns on financial instruments across borders. In this chapter, we use a number of different versions of this general approach to investigate financial integration/capital mobility in our case countries during the last couple of decades. More specifically, we concentrate on cross-country differentials in money market interest rates and test different versions of a basic interest rate parity condition that theoretically explains such differentials. In order to draw conclusions about the degree of international money market integration of our focus countries, we apply a combination of statistical hypothesis testing and extensive use of figures to plot deviations from parity. This approach is particularly useful to study how the degree of...

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