Measurement of financial integration : theory review and a new approach to Euler test

Abstract

An extension of the Euler test in which the real interest rate differential is explained by the growth rate of real consumption of the domestic and the foreign country, and new proxies developed to measure real interest rate differential instead of ex post real interest rate constitute the backbone of this paper. The proxies are obtained directly from the real economic variables that try to overcome the difficulty of measuring unobservable ex post real interest rates, which, by nature, may contain monetary shocks, and varies considerably according to the reference nominal interest rates and baskets that measures the price developments. In one of the abovementioned proxies, a new factor trying to capture the effect of human capital growth developments on real interest rates has been included. After constructing these new proxies, the validity of the extended Euler test has been checked for 11 OECD countries and the level of these countries’ integration to the world has been tested by taking United States as the foreign country.