Monetary Policy and Exchange-Rate Regimes in Europe: A Structural Approach

Abstract

This paper proposes an empirical framework to analyze monetary policies in a small open economy under fixed exchange rates. First, the analysis proposes a semi-restricted VAR model with the lowest number of restrictions to focus on the effects of the center-country and the Rest-of-the-World monetary policies. Next, we use a fully structural VAR approach where the identifying restrictions are imposed on the short-run behavior of the variables. The model is applied to the EMS experience of France, Italy and the Netherlands by considring Germany as the center country and the U.S. as the Rest of the World. The presence of imperfect capital mobility allows us to attribute partial monetary independence to the domestic monetary authorities. Innovations in the German monetary policy are found to be highly important for the Dutch monetary policy, but much less for France and especially for Italy. Instead, the U.S. shock plays a particularly relevant role for the French monetary policymaking. There is also evidence of stronger recessionary impact of restrictive German monetary policies on France and Italy rather than the Netherlands. This may explain why the former two countries devalued so many times.

JEL Classification: E42, E61, F33