Limited access Past event
The Exchange Rate Insulation Puzzle
Speaker: Gernot Müller, University of Tübingen
Abstract: The notion that flexible exchange rates insulate a country from foreign shocks is well grounded in theory, from the classics (Friedman, 1953; Meade, 1951), to the more recent open economic literature (Gopinath et al., 2020; Obstfeld and Rogo , 2000). We confront it with new evidence from Europe. Speci fically, we study how monetary, spread, and supply shocks that originate in the euro area spill over to its neighbor countries. We exploit the variation of the exchange rate regime across time and countries to assess whether it 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 speci fications and holds up once we control for global financial conditions. We show that this evidence is not at odds with standard theory: to the extent that central banks target headline consumer price in inflation, they maintain a relatively restrictive monetary policy stance in the face of external shocks. This implies a muted exchange rate response and lack of insulation. Still, at a more fundamental level it appears puzzling that policy makers seem ready to tolerate high exposure of economic activity to external shocks.