The Exchange Rate Insulation Puzzle
101 Pages Posted: 21 Dec 2021
Date Written: December 1, 2021
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: Suggested Citation