Interest Rates Determination and Crisis Puzzle (Empirical Evidence from the European Transition Economies)

Economic theory provides clear suggestions in fixed versus flexible exchange rates dilemma in fighting high inflation pressures. However, relative diversity in exchange rate regimes in the European transition economies revealed uncertain and spurious conclusions about the exchange rate regime choice during last two decades. Moreover, eurozone membership perspective (de jure pegging to euro) realizes uncertain consequences of exchange rate regime switching especially in the group of large floaters. Successful anti-inflationary policy associated with stabilization of inflation expectations in the European transition economies at the end of 1990s significantly increased the role of short-term interest rates in the monetary policy strategies. At the same time, so called qualitative approach to the monetary policy decision-making performed in the low inflation environment, gradually enhanced the role of real interest rates expectations in the process of nominal interest rates determination. However, economic crisis increased uncertainty on the markets and thus worsen expectations of agents. In the paper we analyze sources of nominal interest rates volatility in ten European transition by estimating the structural vector autoregression (SVAR) model. Variance decomposition and impulse-response functions are computed to estimate the relative contribution of inflation expectations and expected real exchange rates to the conditional variability of short-term money market interest rates as well as responses of nominal interest rates to one standard deviation inflation expectations and expected real interest rates shocks. Effects of economic crisis are considered by estimation of two models for every single economy from the group of the European transition economies using data for time periods 2000-2007 and 2000-2011