Macro-prudential policies, the global financial cycle and the real exchange rate

Abstract

This paper examines whether a global financial cycle originating from center economies affects the real exchange rates in peripheral economies and to what extent macro-prudential policies can isolate peripheral economies from this external shock. We build a dynamic stochastic general equilibrium (DSGE) model to describe how macro-prudential policies mitigate the fluctuations of the real exchange rate in a small open economy in response to external shocks, in which households are subject to liquidity constraints. Using a sample of 37 emerging and small advanced economies, we show that a counter-cyclical macro-prudential policy implementation is effective in mitigating the fluctuations in the real exchange rates caused by a U.S. interest rate shock.