Scandinavian Working Papers in Economics

Working Paper Series,
Uppsala University, Department of Economics

No 2005:10: Exchange Rates and Asymmetric Shocks in Small Open Economies

Annika Alexius and Erik Post ()
Additional contact information
Annika Alexius: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden
Erik Post: Department of Economics, Postal: Uppsala University, P.O. Box 513, SE-751 20 Uppsala, Sweden

Abstract: If floating exchange rates stabilize shocks rather than create shocks, a country that joins a monetary union or fixes its exchange rate looses a stabilizing mechanism. We use a first difference structural VAR on trade weighted macroeconomic data to study the role of floating exchange rates for five "small open economies" with inflation targets. By including both domestic and foreign variables and using a combination of long and short-run restrictions, we identify asymmetric shocks more carefully than previous studies. Only in Sweden and Canada does the nominal exchange rate appreciate significantly in response to asymmetric demand shocks and depreciate to asymmetric supply shocks. Most exchange rate movements are caused by speculation and are not responses to fundamental shocks. However, these exchange rate shocks have negligible effects on output and inflation. Our findings indicate that exchange rates are neither stabilizing nor destabilizing but may be loosely characterized as disconnected from the rest of the economy.

Keywords: Exchange rates; asymmetric shocks; structural VAR

JEL-codes: F31

31 pages, March 15, 2005

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