Abstract
In response to an unanticipated monetary policy tightening in the US, real GDP and exports of a typical small open economy fall, despite the depreciation of the local currency. The reason is that the financial channel of the transmission of monetary policy shocks across countries dominates over the traditional expenditure-switching effect. The dominant role of the reserve currency in trade and global financial transactions can account for the evidence in an otherwise standard two-country open economy model with nominal and real rigidities. Yet, even in the presence of a global financial cycle, the exchange rate regime matters. In particular, a peg substantially increases macroeconomic volatility. Conversely, the introduction of an additional policy instrument to manage capital flows dampens economic fluctuations. A tax on domestic credit achieves nearly equivalent results. Tax instruments can insulate the effects of foreign monetary policy shocks on real economic activity in a fixed exchange rate regime, but not on inflation.
Keywords: Exchange rates flexibility, Currency invoicing, Dilemma, Expenditure Switching, Foreign exchange liabilities, Global financial cycle, Trilemma.
JEL codes: E44, E58, F32, F42.
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