The Exchange Rate Insulation Puzzle

84 Pages Posted: 11 Feb 2021

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; University of Rome III - Department of Economics; Centre for Economic Policy Research (CEPR)

Keith Keuster

University of Bonn

Gernot J. Müller

University of Tuebingen - Department of Economics

Sebastian Schmidt

European Central Bank (ECB)

Date Written: January 2021

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.

JEL Classification: E31, F41, F42

Suggested Citation

Corsetti, Giancarlo and Kuester, Keith and Müller, Gernot J. and Schmidt, Sebastian, The Exchange Rate Insulation Puzzle (January 2021). CEPR Discussion Paper No. DP15689, Available at SSRN: https://ssrn.com/abstract=3783904

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

University of Rome III - Department of Economics ( email )

via Ostiense 139
Rome, 00154
Italy
+39 06 5737 4056 (Phone)
+39 06 5737 4093 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Keith Kuester

University of Bonn ( email )

Regina-Pacis-Weg 3
Postfach 2220
Bonn, D-53012
Germany

Gernot J. Müller

University of Tuebingen - Department of Economics ( email )

Mohlstrasse 36
D-72074 Tuebingen, 72074
Germany

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
0
Abstract Views
135
PlumX Metrics