We separately identify domestic and external sources of exchange rate fluctuations in a large sample of small open economies (SOEs). We find that external shocks lead to large and predictable deviations from uncovered interest parity (UIP), while domestic shocks do not. Additionally, external shocks are linked to fluctuations in global risk aversion and US macroeconomic aggregates. We present an SOE model that rationalizes these facts. In the model, global risk aversion shocks drive exchange rate fluctuations, and a country's net external position governs their transmission. We provide evidence that a country's response to external shocks depends on its external position. (JEL F31, F34, F41, F44, O19)
Cormun et al. (Mon,) studied this question.