Does Asia's Choice of Exchange Rate Regime Affect Europe's Exposure to US Shocks?

45 Pages Posted: 26 Feb 2007

See all articles by Bojan Markovic

Bojan Markovic

EBRD - Economics, Policy and Governance; University of Birmingham

Laura Povoledo

University of the West of England - Bristol Business School

Date Written: February 2007

Abstract

In this paper we use a stylised three-country model to analyse how the transmission of US shocks to Europe might be affected by Asia's choice of exchange rate regime. We find that if Asia decides to peg her exchange rate to the dollar, the impact of US shocks on European output and inflation is likely to be bigger than it otherwise would have been. This happens because, without nominal exchange rate flexibility, Asian firms react to the shocks originating in the United States by implementing significant price adjustments, which in turn affect Europe's relative competitive position. On the theoretical side, our results contribute to the literature by suggesting that the shock insulation property of floating exchange rates extends beyond the two countries that have currencies that are free to move. The transmission of shocks between two countries can also be dampened by the choice of floating exchange rates in a third country. On the practical side, we can extend our results to China, the largest Asian economy. If China did eventually decide to float her currency, Europe's exposure to US shocks would decrease. But, our results also suggest that the overall fall in volatility of Europe's inflation and output, following China's floating, might be modest in size.

Keywords: International transmission, exchange rate regimes, Asia, China, Europe

JEL Classification: E30, E42, F41, F42

Suggested Citation

Markovic, Bojan and Povoledo, Laura, Does Asia's Choice of Exchange Rate Regime Affect Europe's Exposure to US Shocks? (February 2007). Bank of England Working Paper No. 318, Available at SSRN: https://ssrn.com/abstract=965494 or http://dx.doi.org/10.2139/ssrn.965494

Bojan Markovic (Contact Author)

EBRD - Economics, Policy and Governance ( email )

One Exchange Square
London EC2A 2JN
United Kingdom

University of Birmingham ( email )

Edgbaston, Birmingham B15 2TT
United Kingdom

Laura Povoledo

University of the West of England - Bristol Business School ( email )

Frenchay Campus
Bristol, BS16 1QY
United Kingdom

HOME PAGE: http://www.povoledo.it

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