The Exchange Rate as a Shock Absorber and Amplifier: An Analysis of the Transmission Channels and the Policy Toolbox in Small Open Economies

What are the most appropriate policy regimes and mix of instruments in small open economies to deal with capital flows volatility and the influence of the global financial cycle? In this article, we review the recent experience of various emerging economies and the arguments in favor of the use of various conventional and unconventional policy tools and approaches. In particular, we analyze the different reasons that prevent full exchange rate flexibility as a shock absorber, which demands, in many circumstances, the use of alternative tools, sometimes as substitutes but in many other cases as complements of FX flexibility: FX markets interventions, macroprudential regulations and capital flow management measures. Our main contribution is to present the FX transmission channels to the macro/financial performance and the tools currently used by many Central Banks to deal with FX shocks identified by an extensive literature in a systematic and orderly manner. We conclude that the most appropriate policy responses critically depend, not only on the nature and intensity of the shock, but also on the structural conditions and particular circumstances that each economy exhibits at the "starting point".