Exchange Rate Intervention in Small Open Economies: The Role of Risk Premium and Commodity Price Shocks

We study the effect of country risk premium and commodity price shocks on monetary policy in small open economies. Risk premium shocks not only can explain most of the variance in the exchange rate, but also can expand GDP. Our estimations indicate that the impact of a real depreciation on exports far exceeds not only the balance sheet effect, but also the effect of an increase in the cost of imported inputs. However, in a more complex environment, where the changes in exports are offset by negative shocks to commodity prices, the contraction stemming from the balance sheet effect reappears. (C) 2012 Elsevier Inc. All rights reserved.