The Exchange Rate Insulation Puzzle

Abstract

The notion that flexible exchange rates insulate a country from foreign shocks is well grounded in theory, from the classics (Meade, 1951;Friedman 1953), to the more recent open economy literature (Obstfeld and Rogoff, 2000). We confront it with new evidence from Europe. Specifically, we study how shocks that originate in the euro area spill over to its neighboring countries. We exploit the variation of the exchange rate regime across time and countries to assess whether the regime alters the spillovers: it does not -flexible exchange rates fail to provide insulation against euro area shocks. This result is robust across a number of specifications and holds up once we control for global financial conditions. We show that the workhorse open-economy model can account for the lack of insulation under a float, assuming that central banks respond to headline consumer price inflation. However, it remains puzzling that policy makers are ready to forego stabilization of economic activity to the extent we found in the data.

Central bank information effects and transatlantic spillovers

“…Instead, the literature on the international spillovers of ECB monetary policies focuses on the non-eurozone European countries (e.g. Bluwstein and Canova, 2016;Moder, 2019;Feldkircher et al, 2020;Ellen et al, 2020;Corsetti et al, 2021), on specific subsets of monetary policy interventions (Georgiadis and Gräb, 2016), or both.…”

“…Franz (2020) studies a panel of exchange rates and shows that speculative currencies appreciate after positive ECB information shocks. Furthermore, controlling for central bank information effects is important for precisely isolating the spillovers of monetary policy shocks in Ca ' Zorzi et al (2020); Miranda-Agrippino and Rey (2020); Corsetti et al (2021); Miranda-Agrippino and Nenova (2021).…”

When Domestic and Foreign QE Overlap: Evidence from Sweden

“…One can also compare the spillovers of conventional and unconventional monetary policy. Corsetti et al (2021) show that the ECB conventional monetary policy shocks generate a similar response of output and inflation in the euro area as in its neighbouring countries. Therefore, our results for the ECB QE shocks are in line with evidence on spillovers of conventional monetary policy.…”

Global Monetary and Financial Spillovers: Evidence from a New Measure of Bundesbank Policy Shocks

“…Other closely related works include Dedola, Rivolta, and Stracca (2017), Iacoviello and Navarro (2019) and Corsetti, Kuester, M üller, and Schmidt (2021). 2 An extension to an advanced-and-emerging economy sample (Obstfeld, Ostry, and Qureshi, 2019) also argues that the evidence still supports the baseline trilemma view.…”

“…Early works that studied Fed spillovers includeForbes and Chinn (2004),Canova (2005), andEhrmann and Fratzscher (2009). Another recent strand of the literature has looked at spillovers from both the U.S. and the euro area, e.g.,Ehrmann and Fratzscher (2005),Fratzscher, Duca, and Straub (2016),Brusa, Savor, and Wilson (2020).2Corsetti et al (2021) show that after 1999, euro area shocks seem to have similar spillover effects to neighboring countries irrespective of their exchange rate regime.…”