Interest Rates Across the World : Global, Regional, and Idiosyncratic Factors

The world interest rate is a key determinant of borrowing and lending behavior and plays a central role in most open-economy macro/finance models. This paper uses a dynamic factor model to construct a world interest rate based on short run interest rates of over 70 countries. Such a process should better extract a common trend than simple averages. With regional factors incorporated, the obtained global factor can appropriately reflect overall global influences. We find that while the global factor is important, both regional and local factors play an important role in determining local rates, and consistent with recent evidence, the global rate is on a long run secular downward trend. Furthermore, capital account openness strongly affects both the co-movements of local--regional and local--world rates, and exchange rate regimes have in an important impact as well. Finally, we also make methodological suggestions for the practical use of dynamic factor models especially when the proper regional groupings are not obvious