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Does Asia's choice of exchange rate regime affect Europe's exposure to US shocks?

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  • Bojan Markovic
  • Laura Povoledo

Abstract

In this paper we use a stylised three-country model to analyse how the transmission of US shocks to Europe might be affected by Asia’s choice of exchange rate regime. We find that if Asia decides to peg her exchange rate to the dollar, the impact of US shocks on European output and inflation is likely to be bigger than it otherwise would have been. This happens because, without nominal exchange rate flexibility, Asian firms react to the shocks originating in the United States by implementing significant price adjustments, which in turn affect Europe’s relative competitive position. On the theoretical side, our results contribute to the literature by suggesting that the shock insulation property of floating exchange rates extends beyond the two countries that have currencies that are free to move. The transmission of shocks between two countries can also be dampened by the choice of floating exchange rates in a third country. On the practical side, we can extend our results to China, the largest Asian economy. If China did eventually decide to float her currency, Europe’s exposure to US shocks would decrease. But, our results also suggest that the overall fall in volatility of Europe’s inflation and output, following China’s floating, might be modest in size.

Suggested Citation

  • Bojan Markovic & Laura Povoledo, 2007. "Does Asia's choice of exchange rate regime affect Europe's exposure to US shocks?," Bank of England working papers 318, Bank of England.
  • Handle: RePEc:boe:boeewp:318
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    1. Blake, Andrew P & Markovic, Bojan, 2008. "The conduct of global monetary policy and domestic stability," Bank of England working papers 353, Bank of England.
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    3. Hirakata, Naohisa & Iwasaki, Yuto & Kawai, Masahiro, 2014. "Emerging Economies' Supply Shocks and Japan's Price Deflation: International Transmissions in a Three-Country DSGE Model," ADBI Working Papers 459, Asian Development Bank Institute.

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