Aspects of the Monetary Transmission Mechanism under Exchange Rate Targeting: The Case of France

In contrast with most of the literature on the monetary transmission mechanism, which focuses on a domestic short-term interest rate as the policy instrument, this paper examines separately the impact of the anchor currency interest rate and of the domestic premium on economic activity in France. In addition to being motivated by theoretical reasons, such a decomposition attempts to capture the framework within which French monetary policy is conducted. Similar considerations motivate the use of specifications of a vector autoregression model allowing contemporaneous changes in the exchange rate and in long-term interest rates to affect the interest rate differential. An increase in the German component of the French short-term interest rate is estimated to have a strong dampening effect on output, while the corresponding effect of an increase in the premium is negligible. This suggests that episodes of a widening of interest rate differentials to defend the franc had a smaller effect on activity than is often supposed. Among the channels usually considered as important for the transmission of monetary policy, the money channel is estimated to play an insignificant role, while the credit channel is found to be important. This appears to reflect certain features of the French economy, notably the limited role of commercial paper, the importance of small enterprises, and banking capitalization. Because the impact of Economic and Monetary Union (EMU) on the transmission mechanism can be analyzed in terms of the elimination of the interest rate premium, the small estimated impact of the premium suggests that EMU would entail only marginal changes in the monetary transmission mechanism in France. In contrast, variations in short-term interest rates in the EMU area are likely to exert a significant influence on activity in France.