The Exchange Rate Insulation Puzzle

101 Pages Posted: 21 Dec 2021

See all articles by Giancarlo Corsetti

Giancarlo Corsetti

University of Cambridge; 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: December 1, 2021

Abstract

We confront the notion that flexible rates insulate a country from external disturbances with new evidence on spillovers from euro-area shocks to neighboring countries. We find that in response to euro-area shocks, spillovers are not smaller, and currency movements not significantly larger, in countries that float their currency, relative to those that peg to the euro—the insulation puzzle. Unconditionally, however, currency volatility is significantly higher for floaters. A state-of-the-art open-economy model can fit our conditional evidence on lack of insulation, provided monetary policy targets headline inflation, but only at the cost of missing the unconditional evidence on currency volatility.

Keywords: exchange-rate disconnect, exchange-rate regime, external shock, insulation, international spillovers

JEL Classification: F41, F42, E31

Suggested Citation

Corsetti, Giancarlo and Corsetti, Giancarlo and Kuester, Keith and Müller, Gernot J. and Schmidt, Sebastian, The Exchange Rate Insulation Puzzle (December 1, 2021). ECB Working Paper No. 2021/2630, Available at SSRN: https://ssrn.com/abstract=3990468 or http://dx.doi.org/10.2139/ssrn.3990468

Giancarlo Corsetti (Contact Author)

University of Cambridge ( email )

Trinity Ln
Cambridge, CB2 1TN
United Kingdom

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
107
Abstract Views
415
rank
362,949
PlumX Metrics