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We thank, without implication, Jacques Artus, Max Watson, and the staff of the Banque de France for helpful comments, and Susan Becker for research assistance.
These results reflect the historical behavior of the interest differential, where shocks last for just a few months. Simulations reflecting a somewhat different stochastic process, indicate that a sustained increase in the short-term interest differential would have a significant impact on output.
See, for instance, Hamilton (1994), for an explanation of the relationship between the B0 matrix and the Choleski decomposition.
A typical justification for this is that, while changes in the policy variable are easily observed and can be expected to have a contemporaneous impact on the behavior of economic agents, information lags concerning the evolution of other variables that the monetary authorities may be monitoring precludes systematic within-the-period response of the policy variable.
Interpretation of the results is rendered more difficult by the fact that confidence intervals around the impulse response functions are not provided.
Another particularly puzzling result in Sims (1992) is that changes in the French short-term rate appear to have a substantial impact on the world commodity price index.
Apart from this two-asset feature, the “money” channel is consistent with a wide variety of theoretical formulations. For instance, it is consistent with the textbook IS/LM model as well as with the dynamic equilibrium/cash in advance models of Rotemberg (1984), Grossman and Weiss (1983) and Lucas (1990).
Because this effect operates at the margin, it is valid even when reserve requirements are low (as in France).
See, for example, Bernanke and Gertler (1987).
All variables are included as logs, with the exception of the interest rate variables which are entered as a percent. A list of symbols, as well as a description of the variables and data source, is provided in the Data Appendix.
There is strong evidence that the Banque de France official rates essentially drive money market rates, in particular overnight rates.
The difficulty arises because not only impulse responses are non-linear functions of the autoregressive coefficients obtained from the VAR, but the cross-equation restrictions imposed on the system imply that the covariance matrix of these coefficients is not the same as that for OLS (Hamilton, 1994; Zellner, 1971). The Monte Carlo procedure used in this paper is based on the one suggested in Doan (1992).
It should, however, be recalled that these authors use error bands 1 standard error in width, while ours are 2 standard errors in width. In that sense, our statistical significance tests are more stringent.
These reasons extend for the case of other ERM currencies (see Halikias and Levy, 1996 for a discussion regarding the Dutch guilder).
No matter what the direction in which causality might run.
In this connection, it would appear illustrative to recall that, during the months immediately preceding the 1993 EMS crisis, the Bundesbank had made clear that it would be willing to ease interest rates if the DM were to be allowed to revalue. See also Clarida and Gertler (1996).
This is done to facilitate comparison of results; use of a composite of core ERM currencies yields analogous results.
The persistence of shocks in the German and domestic components is also different, with shocks to the first component lasting about three times longer than those to the domestic premium. It is conceivable that empirically this difference in persistence has a bearing on the distinct impact of innovations in these variables on output and intermediary variables.
The cumulative output loss in the first year following a one percent increase in the German component of interest rates was estimated at about 0.7 percent of annual GDP (with a standard deviation of 0.25 percent); the output loss of owing to an increase in the domestic component was estimated at 0.2 percent of GDP (with a standard deviation of 0.1 percent). The depressing effects from an increase in the German component grow in the second year, while those from an increase in the French rate vanish.
See, however, Keating (1990) for some examples of rational expectations VAR models which are immune to this problem, albeit at the cost of imposing a more restrictive structure.
The impact of innovations in the anchor interest rates on output is not homogeneous across countries. Halikias and Levy (1996), for instance, find a smaller impact in the case of the Netherlands.
The often used approach of ensuring that the results are not overly sensitive to the particular ordering of the variables under consideration that has been chosen does not remove the essential arbitrariness of the Choleski decomposition, which fundamentally emanates from restricting attention to strictly recursive models.
These exclusion restrictions are less strong than one might think. It should be recalled that the coefficients of matrix B0 refer to the correlations between the innovations of the variables under consideration, rather than the variables themselves. Thus, no restrictions are imposed on the contemporaneous relation between the forecastable part of any set of variables.
Although standard deviations were not computed, they should be very similar for both factorizations, given that the factorization matrices were very similar and the distribution of the dynamic coefficients is the same.
An alternative formulation that allows contemporaneous feedback from the bilateral exchange rate to the differential, while remaining within the confines of the Choleski decomposition (and thus failing to incorporate a within-period impact of the differential on the bilateral exchange rate), also confirms the thrust of the results.
In order to distinguish between those two competing hypotheses, it would have been necessary to employ (non-recursive) identification restrictions that allow explicitly introducing key testable implications of the models in question, e.g. along the lines discussed by Blanchard and Quah (1989) and extended by Gali (1992) in his test of the empirical relevance of the IS-LM model for the U.S. economy.
Recourse by French firms to domestic money market amounts to about 5 percent of the debt of these firms; negotiable instruments as a whole represent about 15 percent of total credit to firms.
It should be noted that the two channels described above are not mutually exclusive. In fact, most proponents of the credit view tend to regard them as complementing each other, with the effect of a monetary policy change via the credit channel simply magnifying its effect via the money channel.