Decomposing Interest Differentials: An International Borrowing and Lending Approach

Abstract

This paper proposes a new economy-wide framework for decomposing international interest differentials based on aggregate borrowing and lending behaviour in economies whose domestic capital markets are highly globally integrated. Using macroeconomic rather than microeconomic concepts, this alternative approach demonstrates how key inter-relationships involving relative inflation levels and exchange rate expectations govern "average" domestic and foreign interest differentials. It also contributes by identifying different kinds of risk premia that arise due to economy-wide factors such as the level of foreign debt and country and political factors. Unlike standard interest parity approaches, based simply on arbitrage of financial asset returns, it shows that changing exchange rate expectations influence international interest differentials through both excess domestic borrowing and foreign lending behaviour.