Does the Financial Channel of Exchange Rates Offset the Trade Channel?

Abstract

While the trade channel indicates that an exchange rate depreciation will stimulate domestic economic activity, the financial channel can have the opposite effect. When banks and non-banks have foreign currency liabilities, an exchange rate depreciation has valuation effects that can lead to a tightening in domestic financial conditions. Using trade-weighted exchange rates and new BIS-constructed debt-weighted exchange rates to separate these influences, this article finds that the financial channel partly offsets the trade channel for emerging market economies but the effect is weaker for advanced economies.

JEL Classification: F31, F41, F43, G15