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This research examines the insulation effect of flexible exchange rates against external shocks in the euro area.

May 7, 20260 citationsOpen Access

Exchange Rate Insulation Revisited

GCGiancarlo CorsettiBoston College KKKeith KuesterGoethe University Frankfurt GMGernot J. Müller

Key Points

This research examines the insulation effect of flexible exchange rates against external shocks in the euro area.
Utilizes high-frequency data
Analyzes responses of floats and pegs to monetary policy shocks
Employs a HANK model for explanation of findings
Flexible exchange rates experience depreciation in response to monetary policy shocks.
Countries with floats and pegs contract equally during external shocks.
Foundational economic theories are challenged by the observed results.

Abstract

We confront the notion that flexible exchange rates insulate countries from external disturbances with new evidence for the euro area (EA) and 20 of its neighbors. Using high-frequency data, we first establish that countries with flexible exchange rates (“floats”) let their currencies depreciate in response to EA monetary policy shocks, while“pegs” raise interest rates. Yet at business cycle frequency, these depreciations do not translate into insulation: floats contract just as much as pegs—not only in response to monetary policy shocks but also to other shocks originating in the EA. This result appears puzzling in light of received wisdom, but we show that it can be rationalized within a state-of-the-art HANK model and flesh out the underlying transmission channels.

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