Working Paper: CEPR ID: DP15689
Authors: Giancarlo Corsetti; Keith Kuester; Gernot Müller; Sebastian Schmidt
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.
Keywords: external shock; international spillovers; exchange rate insulation; monetary policy; dominant currency pricing; effective lower bound
JEL Codes: F41; F42; E31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central banks responding to headline consumer price inflation (E31) | potential insulation afforded by flexible exchange rates (F31) |
| flexible exchange rates (F31) | insulation from euro area shocks (F36) |
| euro area shocks (F36) | responses in economic indicators (industrial production, unemployment rates, consumer prices, interest rates) (E30) |
| identical propagation of euro area shocks (F41) | exchange rate insulation puzzle (F31) |