The Exchange Rate Insulation Puzzle

Despite widespread skepticism, the notion that flexible exchange rates insulate a country from foreign shocks is central to modern macroeconomics. We confront it with new evidence from Europe. We show that spillovers from euro-area shocks to neighbouring countries are no smaller for floating exchange rates than for pegs—the exchange rate insulation puzzle. We show that a standard business cycle model predicts large spillovers under a float provided that monetary policy chooses to target headline inflation. Yet, the model cannot simultaneously account for our conditional evidence and the fact that business cycles appear no different under pegs and floats.