According to the received wisdom, flexible exchange rates insulate economies from external shocks. The exchange rate, so the argument goes, operates as an automatic shock absorber that adjusts to soften the impact of the shocks even if monetary policy does not react at all (Friedman 1953). Today’s central banks adjust interest rates actively as economic conditions change, first and foremost when consumer prices change. This may limit the extent of insulation from external shocks and it may limit the extent of insulation that we observe in practice. Being aware that the observed merits of flexible exchange rates themselves result from a policy choice seems particularly relevant today when central banks around the globe are putting their strategies up for review (Eggertsson et al. 2020, Angeloni 2020).
These insights emerge from a recent paper in which we establish new evidence on how external shocks give rise to the perennial conflict between stabilising prices and economic activity (Corsetti et al. 2021). In our empirical analysis we study how shocks that originate in the euro area spill over to its neighbouring countries and, in particular, whether spillovers depend on the neighbour’s exchange rate regime vis-à-vis the euro. We focus on Europe for two reasons. First, by focusing on the euro area as a source of shocks we steer away from a global (US-dominated) financial cycle that is partly driven by US monetary policy (Rey 2013). Second, there is large variation in the exchange rate regime that the neighbours of the euro area have, both across time and countries. Our results are clear-cut and puzzling at first sight – in response to euro area monetary policy shocks economic activity in the neighbour countries contracts as much as in the euro area, irrespective of whether the neighbours peg their currency to the euro or float. We refer to this finding as the ‘exchange rate insulation puzzle’ – a flexible exchange rate regime does not seem to provide the insulation from external shocks that the received wisdom suggests it should.
The lack of insulation: Evidence from Europe
Our sample includes monthly observations for 20 countries, covering the period from 1999 to 2018. Hence, our estimates are based on 4,800 country-month observations and our empirical strategy exploits the large variation of exchange rate arrangements in our sample. In our baseline, we rely on the de-facto classification of exchange rate regimes that is due to Ilzetzki et al. (2019) and classify about one third of country-month observations as floats. We use local projections to estimate the impulse response of a number of variables to euro area shocks, while conditioning on the exchange rate regime that is in place in the country in the month prior to the shock. In the baseline, we estimate the response to euro-area monetary policy shocks as identified by Jarocinski and Karadi (2020).
Figure 1 Responses to euro area shocks
Figure 1 reproduces the main result from this exercise. The left column shows the response of the euro area itself. Economic activity (measured at monthly frequency by industrial production and unemployment) contracts, inflation (both in terms of the CPI and in terms of producer prices) declines somewhat, and the euro appreciates. Perhaps unsurprisingly, we observe the same pattern for the neighbouring countries when they peg their currency to the euro (middle column). Yet, the pattern is also very similar in the right column, which shows the effect of the shocks in neighbouring economies when the neighbours float their currency. So, this is the exchange rate insulation puzzle – flexible exchange rates do not seem to provide any insulation from external shocks. In the paper we document that this pattern appears to be robust across a wide range of alternative specifications, including alternative shock measures and classifications of the exchange rate regime. We also show that the pattern is not driven by specific countries or country groups.
The lack of insulation reflects a policy choice
To shed some light on the mechanism that causes our empirical findings, we reconstruct our empirical setup within a state-of-the-art open economy model in the spirit of Gopinath et al. (2020). The model features one large country, representing the euro area to which we refer as “Foreign”, and a small country, representing a generic neighbour country. In the model goods markets are not fully integrated, inducing home bias in demand – firms may employ imported inputs in production, prices are rigid and, importantly, both exports and imports are priced in the large trading partner’s currency (in line with evidence that we provide in the paper, the euro is the dominant currency in the international trade in Europe). Monetary policy adjusts the short-term interest rate in order to meet a well specified target.
Figure 2 Impulse responses to a monetary tightening in model country
Figure 2 again plots impulse responses to a monetary tightening in Foreign (that is, the euro area), but this time in the model. Under a peg (middle column), the adjustment in the neighbour country is perfectly synchronised with the large foreign economy in which the shock originates, just like in the data. Under a float (right column), instead, we display alternative sets of responses because countries can choose many different ways to float. The red line with diamonds represents the policy scenario that provides maximum insulation. In this scenario, the central bank is assumed to set interest rates so as to close the output gap. Since foreign demand falls, so does the natural level of output in the domestic economy – closing the output gap means that output falls a little, too, but much less so than in the foreign country (or under a peg). The exchange rate depreciates sharply (top line, bottom panel). However, since both exports and imports are priced in foreign currency, exchange rate movements do not induce much expenditure switching. Instead, stimulating domestic activity in the face of recessionary foreign shocks requires stimulating domestic demand. This, in turn, calls for a reduction of interest rates, which induces the currency depreciation shown in the figure. As a result, we observe that the shock has a sizeable inflationary impact, both in terms of the CPI and in terms of producer prices. In sum, stabilising domestic activity in the face of recessionary foreign shocks requires tolerating swings in domestic inflation and exchange rates.
The other two lines in the right column show two alternative regimes. Both of these have floating exchange rates and both of these are a form of inflation targeting. The blue line with circles shows a monetary regime of producer-price inflation targeting. In this case the spillovers in activity are notably larger than before. Still, there is some insulation. Indeed, the domestic monetary expansion still induces a substantial depreciation of the nominal exchange rate.
The responses shown as the black lines marked by squares, instead, provide a fundamentally different picture. These responses seem rather consistent with the lack of insulation that we find in the data. Even though the exchange rate is flexible, the model predicts output spillovers that are as large as under a peg. Importantly, these lines correspond to a regime of consumer-price inflation targeting. The rationale for the spillovers is as follows. As illustrated earlier, stimulating domestic activity in the face of recessionary foreign shocks requires tolerating swings in the exchange rate and inflation. Consumer-price (CPI) inflation targeting prevents these. Rather, the policy trade-offs are resolved in favour of stabilising headline inflation at the expense of output gap variability. The exchange rate responds least in this regime – and much less than under output gap targeting.
In our paper, we show that these results are robust to assuming complete exchange rate pass through (so that currency movements could absorb shocks by moving relative prices sufficiently). They also go through in experiments where shocks are large enough to bring policy rates to their lower bound. Next, we show that lack of insulation also characterises economies with symmetrically incomplete pass through (export prices from the euro area are sticky in local currency), provided that there is CPI inflation targeting. In the case of symmetrically incomplete pass-through, exchange rate volatility remains high but is muted by CPI targeting. Once more, the message in all these results is the same – a CPI target causes monetary policy to lean against the exchange rate response, at the expense of economic activity.
The insulation puzzle versus exchange rate volatility
Our finding that bilateral exchange rates with the euro hardly move in response to identified shocks in the euro area does not mean that exchange rate volatility in countries with flexible exchange rates is low. In fact, following Baxter and Stockman (1989), we also compute the unconditional volatility of business cycle indicators. Results are striking. As in Baxter and Stockman, the unconditional volatility in business cycle variables is strictly comparable for pegs and floats – with the exception of the nominal exchange rate, which is notably more volatile for floaters. This suggests a potentially important role of shocks that affect exchange rate volatility but have little bearing on economic activity (Itskhoki and Mukhin 2020), shocks presumably originating in (or propagated by) financial markets.
Looking ahead: The insulation puzzle and monetary policy
Theory and our evidence suggest a specific take on the insulation puzzle. Namely, in our sample, floaters, one way or another, have all chosen a monetary regime of flexible inflation targeting. While this regime has arguably borne benefits in many dimensions, it may have also constrained the exchange rate from operating as an automatic shock absorber in the face of external shocks. The puzzle, then, is what prevents policymakers from exploiting the flexibility inherent in a regime of flexible exchange rates – say, in the choice of the price index defining the inflation target – to improve the policy trade-offs in favour of insulation. It remains to be seen whether the current reassessment of monetary strategies will give rise to different policy choices that will become manifest in different adjustment dynamics in the face of external shocks.
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