Economic shocks rarely stop at national borders. Understanding how they spread across countries is essential for designing effective economic policy. In their paper Exchange Rate Insulation Revisited, Giancarlo Corsetti, Keith Kuester, Gernot J. Müller, Sebastian Schmidt, and Ben Schumann examine whether flexible exchange rates really protect countries from economic shocks originating in the euro area.
For decades, a central idea in international economics has been that countries with floating exchange rates are better able to absorb external shocks than countries with fixed exchange rates. When a country's currency is allowed to adjust freely, it can depreciate in response to adverse developments abroad, making exports more competitive and helping to stabilize the economy. The new study asks whether this widely accepted view holds in practice.
To answer this question, the researchers study 20 European economies outside the euro area that are closely connected to it through trade and financial markets. Some of these countries have floating exchange rates, while others peg, or fix, their currencies to the euro. This variation allows the authors to compare how different exchange rate regimes affect the transmission of shocks from the euro area.
The study combines several sources of data covering the period from 1999 to 2025. The researchers analyze monthly macroeconomic indicators such as industrial production, inflation, unemployment, exchange rates, and interest rates. They also use high-frequency financial market data collected around European Central Bank policy announcements to identify unexpected changes in monetary policy. Monetary policy refers to decisions by a central bank that influence interest rates and overall financial conditions in the economy.
The analysis focuses first on monetary policy shocks originating in the euro area. It then examines whether the same patterns hold for broader business cycle shocks, which reflect changes in overall economic activity, and exchange rate shocks that affect the value of the euro relative to other currencies.
The results show that financial markets react differently depending on the exchange rate regime. Following a euro area monetary policy shock, countries with floating exchange rates typically experience a depreciation of their currencies, while countries with fixed exchange rates mainly adjust through changes in domestic interest rates. These responses are broadly consistent with standard economic theory.
However, the picture looks very different when considering the real economy. Despite their different financial responses, countries with floating exchange rates experience declines in economic activity that are remarkably similar to those in countries with fixed exchange rates. In other words, exchange rate flexibility provides much less insulation from external shocks than many economic models would predict.
The researchers find that this result is not limited to monetary policy. Similar patterns emerge when they examine broader business cycle shocks and exchange rate shocks originating in the euro area. Across different types of disturbances, countries with floating exchange rates remain almost as exposed as countries that peg their currencies to the euro.
To understand why this happens, the authors complement their empirical analysis with a macroeconomic model that accounts for differences across households. The model suggests that exchange rate movements affect household income, spending, and borrowing in ways that weaken the stabilizing role of a floating currency. As a result, countries that are highly integrated through trade and finance can remain vulnerable to foreign shocks even when their exchange rates adjust freely.
The study also tests its findings using a range of alternative specifications and robustness checks. Regardless of the exact approach, the main conclusion remains the same: flexible exchange rates provide significantly less protection from euro area shocks than conventional theory suggests.
These findings have important implications for economic policy. Exchange rate flexibility remains an important policy tool, but the study suggests that it should not be viewed as sufficient on its own to shield economies from external disturbances. For countries that are closely integrated with their trading partners, financial structures and the links between households and international markets also play an important role in shaping how shocks spread.
By revisiting one of the central assumptions of international macroeconomics, the study provides new evidence on how economic shocks are transmitted across borders. As economies become increasingly interconnected, understanding these transmission channels is essential for designing effective and resilient economic policies.
About the Authors
Giancarlo Corsetti
Giancarlo Corsetti is Pierre Werner Chair at the Robert Schuman Centre and Professor of Economics at the European University Institute. His contributions range from models of the international economy and open macro models, to empirical and theoretical work on currency, financial and sovereign crises, monetary and fiscal policy, and international finance.
Keith Kuester
Keith Kuester is Professor of Economics at the University of Bonn. His research focuses on macroeconomics, applied econometrics, monetary economics, labor economics.
Gernot J. Müller
Gernot J. Müller is Professor of Economics at the University of Tübingen. His research interests include macroeconomics, fiscal and monetary policy, computational methods, inequality.
Sebastian Schmidt
Sebastian Schmidt is an economist at the European Central Bank and CEPR Research Affiliate. His research focuses on macroeconomics and monetary economics, and international economics.
Ben Schumann
Ben Schumann is an Assistant Professor (with Tenure Track) at the Humboldt-Universität zu Berlin and a research fellow at the Berlin School of Economics and the DIW Berlin whose research interests lie in international macroeconomics, monetary and fiscal policy, climate change, time series econometrics, and Bayesian estimation.
