Exchange rate in emerging markets: Shock absorber or source of shock?

Pym Manopimoke, Nuwat Nookhwun and Jettawat Pattararangrong

Journal of International Money and Finance, 2024, vol. 148, issue C

Abstract: This paper examines the stabilization role of flexible exchange rates for emerging economies within the Latin America and Asia regions. Based on a structural VAR model, we utilize zero, sign and exchange rate pass-through restrictions to identify structural macroeconomic shocks. Overall, we find that exogenous exchange rate shocks drive around half of total exchange rate fluctuations in emerging economies. Despite this predominant role, we find evidence that exchange rates do not act as a source of shocks to the real economy, but they instead absorb and reduce output growth and inflation volatilities. Based on counterfactual analyses, we further find that this shock-insulation property is highly shock-dependent, where the benefits of flexible exchange rates are sizable for demand and global monetary policy shocks, but are overall small in the face of supply shocks. Results also differ across time horizons, where the shock stabilization benefits are mainly limited to the short run for output, but also extend to the medium term for inflation. We also find that the net benefits of flexible exchange rates as a shock absorber are in general larger for emerging economies in Latin America than in Asia, particularly during crises periods. Finally, while we find that the stabilization role of exchange rates hinges upon the nature of underlying structural shocks, there is also a positive association with structural determinants such as a country's degree of exchange rate flexibility and trade openness.

Keywords: Flexible exchange rate; Shock absorber; Exchange rate pass-through; Shock dependency; Structural VAR (search for similar items in EconPapers)
JEL-codes: C32 E44 F31 F41 (search for similar items in EconPapers)
Date: 2024
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Working Paper: Exchange Rate in Emerging Markets: Shock Absorber or Source of Shock? (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jimfin:v:148:y:2024:i:c:s0261560624001359

DOI: 10.1016/j.jimonfin.2024.103148

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