Looking for Contagion: Evidence from the ERM
Carlo A. Favero, Francesco Giavazzi
NBER Working Paper No. 7797
This paper applies a full-information technique to test for the presence of contagion across the money markets of ERM member countries. We show that whenever it is possible to estimate a model for interdependence, a test for contagion based on a full information technique is more powerful. We test for the presence of contagion after having identified episodes of country-specific shocks, whose effects on other European markets are significantly different from those predictable from the estimated channels of interdependence. Using data on three-months interest rate spreads on German rates for seven countries over the period 1988-1992, we are unable to reject the null of contagion. Our evidence suggest that contagion within the ERM was a general phenomenon, not limited to a subset of weaker countries, the exception in the sample being France. Our results are mute as to the question of what lies behind these episodes of contagion; they show, however, that it is not always true that one only detects contagion when one applies poor statistical techniques.