International spillovers and exchange rate dynamics (at the effective lower bound)

In this paper we revisit the insulation properties of flexible exchange rates in the face of international spillovers. We focus on periods where monetary policy is constrained by an effective lower bound. First, we establish new evidence for Europe. We find, in particular, that the neighbors of the euro area absorb adverse growth spillovers fairly well, in particular if interest rates are close to the effective lower bound. Importantly, the exchange rate tends to depreciate vis-a-vis the euro in response to adverse euro area growth shocks. Second, we put forward a New Keynesian two-country model where the domestic economy faces a large external shock because the foreign economy experiences a large recession. We study the response of the exchange rate to this shock and ask whether it contributes towards stabilizing the domestic economy. We find a) that the exchange rate depreciates strongly and that b) the economy remains more insulated under flexible exchange rates than under an exchange rate peg—independently of whether export prices are sticky in domestic or in foreign currency. However, if prices are sticky in foreign currency, domestic interest rates need to be lowered much more strongly. It is thus more likely that the zero lower bound starts to bind in the domestic economy as well.