Exchange Rate Insulation Revisited

Giancarlo Corsetti, Keith Kuester, Gernot J. Müller, Sebastian Schmidt, Ben Schumann and Gernot Müller

No 12635, CESifo Working Paper Series from CESifo

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.

Keywords: exchange-rate regime; Insulation; external shock; exchange-rate disconnect; monetary policy (search for similar items in EconPapers)
JEL-codes: E31 F42 (search for similar items in EconPapers)
Date: 2026
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Persistent link: https://EconPapers.repec.org/RePEc:ces:ceswps:_12635

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