“According to the received wisdom, flexible exchange rates insulate economies from external shocks. The exchange rate should operate as an automatic shock absorber, and adjusts to soften the impact of the shocks”, says Professor Giancarlo Corsetti, a Professor of Macroeconomics at the Faculty of Economics. “However, our research shows this isn’t the case.”
The paper The Exchange Rate Insulation Puzzle by Giancarlo Corsetti, Keith Kuester, Gernot J. Müller, and Sebastian Schmidt examines monetary tightening in a euro area country. It finds the adjustment in the neighbouring country is perfectly synchronised with the euro-area economy in which the shock originates. Economic activity falls in tandem.
“We find that, in the European countries that pursue a floating exchange rate regime in our sample, the bilateral exchange rates with the euro hardly move in response to the specific euro area shocks that we analyse. Remarkably, however, this does not mean that overall exchange rate volatility in these countries is low, as their currencies respond to many other shocks,” says Professor Corsetti. “The puzzle, then, is what prevents policy makers 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.”
Central banks actively adjust interest rates as economic conditions alter, to keep consumer prices changes in line with their inflation target. If inflation increases, interest rates go up to put a brake on the economy. External shocks typically rise to a conflict between stabilising prices and economic activity, to the extent that the central banks respond strongly to imported inflation, and this tends to appreciate the exchange rate, discouraging exports and thus growth.
Depending on how the central bank balances out the two objectives, say by targeting GDP deflator or PPI inflation instead of consumer price inflation, its policy may translate into more ‘insulation’ of domestic economic activity from contractionary external shocks.
The full paper The Exchange Rate Insulation Puzzle is available at: http://www.econ.cam.ac.uk/research/cwpe-abstracts?cwpe=2109
