Responses of Foreign Exchange Market to External Shocks: What Makes Differences?

Abstract

This study investigates the role of external shocks on the stability of the foreign exchange(FX) market in a large panel of fifty advanced and emerging economies. I allow each country’s response of FX rate and capital inflows to vary according to institutional and economic factors through local projection methodology with country-level panel data. The results show that the negative impact of external shocks, such as US monetary policy and geopolitical risks, on the small open economies is substantial. Moreover, unanticipated US monetary tightening has a greater impact on exchange rates and capital inflows in emerging market economies compared to advanced economies. Furthermore, I test for state-dependence of the responses and discover that the effects of external shocks on the foreign exchange market are more pronounced in economies with a high sovereign debt ratio, high external debt ratio, or commodity-exporting ones. In addition, an economy with a high degree of trade openness or highly diversified exports is more likely to alleviate the negative spillovers of external shocks to the FX market.