External Shocks, Policies, and Tail-Shifts in Real Exchange Rates

Nicolas Magud and Samuel Pienknagura

No 2023/129, IMF Working Papers from International Monetary Fund

Abstract: We use panel quantile regressions to study extreme (rather than average) movements in the distribution of the real effective exchange rate (REER) of small open economies. We document that global uncertainty (VIX) and global financial conditions (U.S. monetary policy) shocks have a strong impact on the distribution of the REER changes, with larger impacts in the tails of the distribution, and especially in economies with shallower FX markets, lower central bank credibility, and higher credit risk (i.e., weaker macro fundamentals). Foreign exchange intervention (FXI) partially offsets the impact of these shocks, especially in the left tail (large depreciations) and particularly in economies with weaker fundamentals but, more importantly, when FXI is used sporadically. Thus, our results highlight the importance of deepening FX markets, improving central bank credibility, and strengthening macro fundamentals against the potential dynamic trade-offs of overreliance on a policy that would exacerbate the previously mentioned frictions. While our results point to low effectiveness of capital flow management in preventing large REER movements, they seem to enable more impactful foreign exchange intervention in the immediate aftermath of shocks.

Keywords: Real exchange rates; external shocks; foreign exchange intervention; capital controls; central bank credibility; IMF working paper 23/129; REER distribution; VIX shock; FXI effectiveness; Real effective exchange rates; Currency markets; Depreciation; Global (search for similar items in EconPapers)
Pages: 51
Date: 2023-06-23
New Economics Papers: this item is included in nep-cba, nep-mon and nep-opm
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