empirical economics, VoL 6, 1981, page 1-9. 9 Physica-Verlag, Vienna.

Interest Rates and Investment in West Germany t )

By R. T. Baillie and P. C. McMahon, Birmingham 2)

Abstract: Causality tests due to Granger [1969], Pierce/Haugh [1977], and analysis of residuals
from Box-Jenkins models are applied to investment, three interest rate series, and output for West
Germany from 1960 to 1978. Results are reported for two separate periods which axe distinct due
to changes in government policies.
We conclude that investment is inelastic with respect to nominal short-term interest rates and
the real rate of interest. However, investment does appear influenced by nominal long-term interest
rates, even after government policies had moved towards controlling money stock rather than
operating directly on interest rates.

1. Introduction

The effectiveness of monetary and fiscal policies and the consequent stimulation of
growth can, among other factors, crucially depend on the interest elasticity o f invest-
ment. If investment is strongly determined by the rate of interest, the implication is
that a high level of aggregate demand can be achieved by monetary policy.
Neoclassical theory considers investment to be adjusting the capital stock to a de-
sired profit-maximizing level, a simple variant of this theory is depicted by making in-
vestment a function of the expected real rate of interest. However, as described by
Leijonhufvud [ 1968], some Keynesians and generally most post-Keynesians, argue that
investment is relatively inelastic with respect to the rate of interest, so that monetary
policy must be supported by appropriate fiscal measures.
In the post-war period the Federal Republic of Germany has, in c o m m o n with
many other countries, pursued the objectives of high and steady growth, price stability
and a high level of employment. Its performance as measured by the usual indicators,
singles it out as one of the most successful of all economies. It is difficult to assess the
extent to which this success is due to the policies pursued, but the emphasis on price

1) Most of the work reported in this paper was completed when the authors held Visiting Re-
search Fellowships at the Universitiit des Saarlandes, West Germany, in the summer of 1978. The
hospitality of that institution is gratefully acknowledged, together with the helpful comments of
Rudolf Richter.
2) Prof. R.T. Baillie and Prof. P.C. McMahon, The University of Birmingham, Dept. of Eco-
nomics, Faculty of Commerce and Social Science, P.O.B. 363, Birmingham, B15 2TT, Great
Britain.
 R.T. BaiUieand P.C. McMahon

stability and the importance accorded to monetary policy have certainly contributed
to the success. One of the main aims of the Bundesbank's concept when activating
monetary policy, was to influence the liquidity position of the banks and thus the
level and cost of credit. Borrowed funds have always provided a high proportion of the
total funds needed by German industry with the banks becoming much more willing
to take a longer-term interest in companies. For instance, the medium and long-term
bank credit to companies increased from 7.1% of the total funds used in 1960 to
25.9 % of the total in 1975. Banks have clearly been the main providers of external
funds to German industry, and it is doubtful whether German industry could have
maintained its high level of investment without the support of the banks. Interest is a
tax-deductible expense, whereas dividends are not. To a profitable company, there-
fore, interest charges are shared between the company and the government. Thus, be-
cause loan capital is cheaper than equity capital, it has been argued that the higher the
level of gearing, the lower the cost of capital. The causal chain relating interest rates
movements to investment has been outlined by Irmler [ 1972] and the West German
Bundesbank's concepts of monetary policy is also discussed by Irmler [ 1972] and
Richter/McMahon/Regier [ 1978]. In a more recent treatment a detailed analysis of the
way interest rate changes may transmit impulses to the credit markets has been given
by Streissler/Tichy [1978] in the volume edited by Ehrlicher and Oberhauser.
In this paper we are concerned with the problem of evaluating the empirical evi-
dence concerning the possible relationship between different interest rates series and
investment. A study of investment behaviour is generally accomplished by means of a
formal economic model. However, econometric model building is difficult: both in
terms of the most appropriate dynamic specification, choice of variables and the care.
gorization of explanatory variables as either endogenous or exogenous. The techniques
of causality analysis due to Granger [1969] and Pierce/Haugh [ 1977] can provide use-
ful information on all of these points. The information can be used to specify a model,
to throw light on the strength of the empirical relationships and the length of lag be-
tween variables, and to provide tests of economic theory; all of which can be invalua-
ble for a policy maker. Thus, as recently pointed out by Zellner [ 1979], causality anal-
ysis is not a separate distinct activity, but is an integral part of model building and data
interpretation.
Later in this paper we apply tests for possible causality between non-residential
fixed investment by business firms and two nominal interest rates series, the real rate
of interest and output for West Germany between 1960 and 1978. The direct test of
Granger [ 1969] is supplemented with the test of Pierce/Haugh [ 1977], since the latter
can throw considerable light on the dynamic relationship between variables. See Nel-
son [ 1979] and Schwert [ 1979]. We report results for the two different periods, 1960
to 1972 and 1973 to 1978. It seems appropriate to undertake separate analysis since
following the freeing of exchange rates in early 1973, the Bundesbank changed its
policy from liquidity orientation and operating on interest rates to influence economic
activity, to a monetarist policy of using central bank money stock as an intermediate
target variable.
The plan of the paper is the following: in Section 2, we outline the causality tests
that we use, and in Section 3 and 4 report the results for the periods 1960 to 1972 and
 Interest Rates and Investment in West Germany

1973 to 1978, respectively. Section 5 presents a conclusion to our f'mdings.

2. Methods of Testing for Causality

The usual definition of causality as developed by Granger [ 1969] is that a variable

x causes another variable y, if the one-step-ahead predictor o f y based on all present
and past information including x, has a lower mean-square error than the predictor of
y , based on all present and past information excludingx.
More formally, x causes y if

mse (~ I-4)< rose 0~ IA - - x ) (1)

where A is the set of all past and present available information; A is that same set, but
excluding present information;A - - x is the set of all past available information, but
excluding x ; a n d ; is the minimum mean-square error one-step-ahead predictor based
on a particular information set.
For most practical applications, the concept of "all past and present available infor-
mation" is too general to cope with, and the definition of causality becomes modified
to: "x causesy, ify can be better predicted from the past history o f x andy together,
than from the past o f y alone".
The articles of Pierce [ 1977], and Pierce/Haugh [ 1977], discuss some important
limitations of the definition and subsequent statistical tests. Of particular importance
is the fact that the definition (1) may erroneously conclude that x and y are causally
related when in fact they are unrelated, but are both driven by a third variable which
is unknown to the investigator. Also, the definition is not applicable when y is a purely
deterministic process, or when either x or y are subjected to an optimal control policy.
Granger [ 1969] has shown that under very general conditions, the pair of jointly co-
variance-stationary random variables x and y, will have a vector-autoregressive repres-
entation, of which one equation will be:

Yt = c +l~=O/3/xt. , +1~1 "t',Yt-/ + et (e)

where et is an uncorrelated-random variable. The variable x does not cause y if and
only if/3] = 0 for all/. Granger's direct test requires estimating the unrestricted regres-
sion:
q P
Yt=C +/Z=O/3/xt/ +lY"l'= 7/yt./ + et' (3)

and the restricted regression:

p
tt
Y t = C + ~ 7~Yr.~ +et" (4)
/=1

By denoting the sum of squared residuals from the unrestricted and restricted re-
gressions as S u and S R respectively, we compute the statistic:
 R.T. Baillie and P.C. McMahon

SR m S u n--p--q--2 ]
G= (5)
Su q+l "

Under the null hypothesis that x does not cause y, it follows that G has an F distribu-
tion with q + 1, and n - p -- q -- 2 degrees of freedom.
An alternative to the Granger test is the test developed by Sims [ 1972]. Sims' pro-
cedure is to regress x t on future, current and past lags ofyt, and to test a null hypothe-
sis that the coefficients of the future values ofy t are zero, in which case, x does not
cause y. Hosoya [ 1977] has shown that the Sims and Granger tests are equivalent; al-
though the Granger test is practically easier to apply since i f p and q are large enough,
then the error terms in (3) and (4) will be uncorrelated; whereas the regression errors
in Sims test will typically be autocorrelated.
Another approach to testing for causality has been suggested by Pierce [ 1977], and
Pierce/Haugh [ 1977]. The methodology is to apply appropriate "filters" to both x and
y to reduce them to two white noise series, u and v, respectively. Then u will contain
the component o f x not explicable from its past history alone, and v will comprise the
components of y, not explicable from its past history. Although sequential values o f u
and v are u ncorrelated, u and v may be cross-correlated with one another and we may
calculate the cross-correlation coefficient of lag/', which is defined as:

E (ut. i v t)
#uv (/') = j=...-- 1,0, 1 .... (6)
~/E (u~)E (v~)
The series x is known to causey ifPuv (1) 4=0 for at least one/" > 0 and Puv (/') = 0 for
all j < 0; a full list of the various types of causality is given by Pierce [ 1977].
In practice the filters on b o t h x a n d y have to be estimated, as do the resulting re-
sidual series u and v. The theoretical cross-correlation coefficient (6) is then replaced
with the sample cross-correlation coefficient:
n A A

X ( u^ t . i - a ) (;t
t=l+/"
r~ ~ (/9 = (7)

tV~l (t~t-u): t ~: l (vt--ff)=

Under the null hypothesis that x and y are not related, r (./) will have an asymptotic
normal distribution with mean zero and standard deviation n - I / 2 . To test the null hy-
pothesis that x and y are independent against the alternative hypothesis that x causes
y, we use the statistic:
m
S = n Z r (/3 2 (8)
/=1

where m is the maximum lag considered and n is the number of observations on t2 and
 Interest Rates and Investment in West Germany

~'. If u and v were known, then under the null hypothesis S would be chi-squared dis-
tributed with m degrees of freedom. However, as noted by Pl'erce/Haugh [ 1977], a test
based on (8) using fitted residuals t7 and ~"will have an unknown true significance level
which is less than or equal to the stated level based on knowing the true innovations.
Hence, significant findings are certainly reportable as such, but insignificant results
may be significant if the true rejection region were known.
Similarly, to test the null hypothesis that x and y are independent against the alter-
native hypothesis that either x causes y and/or y causes x, the statistic:
m
S=n Z rO') 2
f~ -rn

will be chi-squared distributed with 2m + 1 degrees of freedom under the null hypoth-
esis. (No significant-level change occurs in this case.) In the rest of this paper we make
extensive use of the S statistic to test for the presence of causality. When there is only
unidirectional causality between x and y a significant r (0) can be interpreted as imply-
ing instantaneous causality between x andy. However, as shown by Price [ 1979] and
Pierce/Haugh [ 1979], no such interpretation can be attached to r (0) when feedback is
present.

3. Analysis for the Period 1960 to 1972

Monthly data were obtained from the Monatsberichte der Deutschen Bundesbank
on the variables:
I: new orders for non-residential fixed investment in manufacturing industry at con-
stant 1970 prices.
i: (Emissionsrendite), which measures long-term interest rates on reserves and govern-
ment securities.
z: (Zins for Dreimonatsgelder), a short-term interest rate series, which is basically an
inter-bank loan rate for acquiring reserves in the money market.
r: the real rate of interest calculated by subtracting the relative change from month to
month in the consumer price index from the long-term interest rate.
y: index of net industrial production at constant 1970 prices.
Before the application of the Granger direct tests it was found necessary to take
ordinary and seasonal differencing of order 12 to make the variables jointly-covariance
stationary. The unrestricted regression (3) and restricted regression (4) were estimated
between each pair of transformed variables. In every case values o f p = q = 12 were
found sufficient to produce uncorrelated residuals, which were tested by calculating
the residuals autocorrelations and carrying out the usual portmanteau test. The results
from the analysis are presented in Table 1.
In general the results support the theory of investment being interest inelastic for
this period, the null' hypothesis that nominal short-term rates and the real rate of inter-
est do not cause investment can be accepted in both cases. There is, however, some
evidence that nominal long-term rates weakly cause investment and that short-term
rates cause long-term rates.
 R.T. Baillie and P.C. McMahon

I z i r

! - 2.062) 1.39 0.70

z 1.61 - 5.381 ) 0.58
i 1.703 ) 1.23 - 0.97
r 0.01 0.39 0.95 -
Key: the (k, 13 th cell gives the effect of lagged values of variable k on variable j
1) denote results which are significant at the 1% level.
2) denote results which are significant at the 5 % level.
3) denotes results which are significant at the 10 % level.
Tab. 1: F statistics from Granger direct tests
I n order to get more insight into the dynamics of these relationships, A R M A mod-
els were fitted to some o f the series o f interest b y applying the m e t h o d o l o g y of Box/
Jenkins [ 1970]:

(1 - - .24L -- .20I, 2) VVx2Zt = (1 - - .71L 12) e l t

(.09) (.09) (.06)
Q(37) = 29.91
(1 - .49L) W l a it = (1 - .19L 3) (1 - - .63L 12) e2t
(.08) (.09) (.07)
Q ( 3 6 ) = 31.29
(1 + .57L + .26L 2 - - .22L 3) (1 + .19L 12) V V l a I t = (1 + .31L 4) (1 -- .30L 12 - - . 3 5 L 24
(.09) (.11) (.11) (.19) (.11) (.20) (.14)

Q (33) = 43.58.

The p o r t m a n t e a u statistic and appropriate degrees of freedom are represented b y Q.

The results o f cross correlating the residuals from these m o d e l s is given in Table 2.
Lag I z i
0-6 I-6 i ~ 10.85 10.48 7.41 7.19
0-12 1-12 ~ 17.08 16.70 14.72 14.50
0-18 1-18 22.72 22.35 19.54 19.32
0-6 1-6 6.40 6.02 ~ 29.233) 20.283)
0-12 1-12 z 13.18 12.80 ~ 35.353) 26.403)
0-18 1-18 20.04 19.67 44.833) 35.883)
0-6 I-6 8.71 8.50 13.631) 4.68
0-12 1-12 i 15.16 14.94 22.20l) 13.25
0-18 1-18 19.80 19.59 28.381 ) 19.43
Key: The table shows the effect of past values of the variables in the row headings on the variables
in the column headings
1) denote results significant at 1% level.
2) denotes results significant at 5 % level.
3 . .
) denotes results slgnificant at 10 % level.
Tab. 2: Pierce-Haugh S statistics
 Interest Rates and Investment in West Germany

It should be noted that the construction of an ARMA model for I t proved to be ex-
tremely difficult and that the omission of any of the nonsignificant parameters result-
ed in a considerably poorer fit with autocorrelated residuals resulting.
The S statistics provide supporting evidence for economic theory that the short-run
interest rates z influence the long-run rates i. The two series have a contemporaneous
correlation of .25, and the cross-correlation coefficient between current i and z lagged
one and two months is .29, and. 18 respectively, (two standard errors being. 17). The
apparent influence of past residuals of i on the residuals of z is weak and is almost en-
tirely due to the correlation at lag zero; for this reason, we can say that the relation-
ship seems to be one way with z causing i. The apparent weak relationship previously
detected between i and I is unsupported by the S statistics; although the residuals of i
lagged four months does have a significant correlation of - . 2 2 with the residuals o f / .
The other main difference between the tests is that from Table 2, z and I appear in.
dependent, whereas the Granger test concluded that z was caused by past investment.
It seems likely that tlae difficulty in finding an ARMA model for I may have been
responsible for not finding any significant results in this case.
Finally, Granger tests were also computed between investment and output. There
was strong evidence of feedback with the F statistic for inclusion of lagged output in
the investment equation being 2.11, and the F statistic for inclusion of lagged invest-
ment in the output equation being 6.14. These results support the accelerater theory
of investment, with investment being especially important in'influencing future growth
and output.

4. Analysis for the Period 1973 to 1978

Following the freeing of exchange rates, this period is noteworthy for the more
monetarist approach of the Bundesbank; in which more attention was focussed on
money stock and less attention was given to influencing interest rates.
The results of the Granger direct tests are given in Table 3; for this time period only
first-order differencing was required since seasonal variation in the variables was rela-
tively slight. As for the first period there was no evidence that the real rate of interest
significantly effected investment. In order to maintain consistency with the first-
period, ARIMA models were also fitted to the series of most interest:

(1 + .43L + .27L 2) VI t
= ~lt
(.13) (.13)
Q (23) = 17.50
(I - 1 .IOL + .26L 2) V z t = (1 - .65L) ~J2t
(.27) (.19) (.13)
Q (22) = 17.49
(I -- .40L) V i t = ~3t
(.12)
Q(24) = 10.25.
 R.T. Baillie and P.C. McMahon

ar g i r
I - 0.86 0.35 0.76
z 1.05 - 1.903 ) 0.63
i 1.13 1.44 - 1.05
r 0.57 0.84 1.04 -
Key: As for Table 1.
Tab. 3: F statistics from Granger direct tests 1973 to 1978

The main difference from the Granger tests is that there is some evidence of nomi-
nal long-term rates weakly affecting investment. It is instructive to follow through the
kind of analysis reported i n N e l s o n [1979], in which the relationship between two
series residuals are examined. We f'md that the current residual of the long-term inter-
est rates series is correlated - . 2 9 with the residual of investment in one months time,
and - . 3 1 with the investment residual in four months time; two standard errors signifi-
cance level being .26. Thus there does seem some evidence of i influencing investment,
even if the effect is relatively weak. On the basis of these admittedly slight effects,
several dynamic regression models were estimated to try and model the effects o f the
influence of nominal long-term interest rates on investment. One o f the more inter-
esting models was:

VI t = (-- 13.94 -- 17.58L 3) (1 + .59L) -~ V i t + u t

(8.15) (8.20) (.35)

ut =- .36ut_ 1 + .27ut. 2 + e t,
(.14) (.14)

Q (16) = 12.2,

~ = 14.43

which implied an average long-run elasticity of - 1.48.

A direct test on output and investment again revealed strong evidence o f past in-
vestment causing output (F statistic of 3.28, which is significant at the one percent
level); whereas past output did not appear to cause investment, (F value of 1.33).

Lag I z i
0-6 1-6 I ~ 6.35 6.20 6.06 5.87
0-12 0-12 8.71 8.56 7.55 7.36
0-6 i-6 7.39 7.24 ~ 17.352 ) 3.87
0-12 1-12 z 11.87 11.72 24.452 ) 10.97
0-6 I-6 i 12"793) 1 2 " 6 0 2 ) 24"271) 10"793)
0-12 1-12 16.24 16.04 31.221 ) 17.743 )
Key: As for Table 2.
Tab. 4: Pierce-Haugh S statistics for 1973 to 1978
 Interest Rates and Investment in West Germany

5. Conclusion

The real rate o f interest and short-term rates o f interest appear to have little or no
effect on investment for b o t h periods o f the study. Conversely, there is evidence that
long-term interest rates do influence investment, even after 1972 w h e n e c o n o m i c poli-
cy in West G e r m a n y shifted away from influencing e c o n o m i c activity through chang-
ing interest rates to controlling m o n e y stock. Before 1972 the accelerator t h e o r y is
supported w i t h past o u t p u t influencing investment; after 1972 such an effect is no
longer apparent, although for b o t h periods investment does seem to have partly caused
future output.

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Received April 1980

(rev. April 1981)