Shocks and Exchange Rates in Small Open Economies
Vito Cormun and Pierre De Leo
We separately identify domestic and external shocks in small open economies, and find that they give rise to markedly different exchange rate dynamics. External shocks feature large and predictable deviations from uncovered interest parity, while domestic shocks do not. Moreover, external shocks are associated with fluctuations in global risk aversion and U.S. macroeconomic aggregates. A small open economy model with imperfect capital markets is consistent with these facts. In the model, global risk aversion shocks drive exchange rate dynamics, and a country’s net foreign asset position governs their international transmission. We provide empirical evidence that a country’s exposure to external shocks indeed depends on its net foreign asset position.