Determinants and international transmission of interest rates: Do foreign reserves and sovereign debt matter?

Abstract

We analyze the role of international reserves and sovereign debt in the determination and international transmission of interest rates. We develop a model that describes the money market equilibrium with capital account openness. It predicts that higher levels of international reserves lead to lower interest rates whereas the effect of higher government debt is ambiguous. We then test empirically these predictions on a panel of 128 countries over 1985–2019. We find that: (i) the transmission of U.S. interest rates to domestic interest rates is stronger in emerging market economies (EMEs) than in advanced economies (AEs) for short‐term interest rates (STIR), and vice versa for long‐term interest rates (LTIR); (ii) international reserves help counteract the transmission of the U.S. policy rate on STIR in EMEs; (iii) a higher sovereign debt level is associated with lower interest rates in EMEs (liquidity effect), but higher interest rates in developing economies (risk premium effect).