Insulation properties of separating exchange markets

Abstract

Insulation properties play an important role for countries in favour of separating rates for separating transactions. Such properties insulate the open economy from monetary and real shocks, of domestic and foreign origins. Through theoretical and numerical analyses, we find that in a unified flexible exchange rate system, portfolio holders' expectations drive the price adjustment, leading to expectations of exchange rate changes. In separating exchange markets, the financial rate reflects the instability of portfolio holders' expectations and capital flows; however, the real exchange rate and hence the macroeconomy is stable. Uncertainty of shocks ceases to affect the real sector of the economy.