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Is the exchange rate a shock absorber or a source of shocks? Evidence from the U.S

Kuhelika De and Wei Sun

Economic Modelling, 2020, vol. 89, issue C, 1-9

Abstract: We examine the stabilization role of the exchange rate in the U.S. economy using a factor augmented vector autoregression model. We find that exchange rate shock explains a large fraction of the variation in exchange rate and transmits major disturbances to the real economy. Further, we find that demand and supply shocks explain less than a quarter of the exchange rate movement. We provide robust evidence that although the exchange rate plays some role as a shock absorber, its role as an independent source of shocks is more dominant for the U.S. economy. The foreign exchange market breeds its own shocks which are destabilizing not only to the value of the dollar but to the overall economy as well. Our results suggest that policymakers need to take foreign exchange market fluctuations into account when making macroeconomic policy decisions.

Keywords: Open economy macroeconomics; Real exchange rate; Monetary policy; Factor augmented vector autoregression model; Shock absorber; Source of shock; U.S. economy (search for similar items in EconPapers)
JEL-codes: C11 C32 E52 F31 F41 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecmode:v:89:y:2020:i:c:p:1-9

DOI: 10.1016/j.econmod.2019.10.015

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