Does Asia's Choice of Exchange Rate Regime Affect Europe's Exposure to US Shocks?

In this paper we use a stylised three-country model to analyse how the transmission of US shocks to Europe might be affected by Asia's choice of exchange rate regime. We find that if Asia pegs its exchange rate to the dollar, the impact of US shocks on European output and inflation is likely to be bigger than it otherwise would have been. This happens because, without nominal exchange rate flexibility, Asian firms react to the shocks originating in the United States by implementing significant price adjustments, which in turn affect Europe's relative competitive position. On the theoretical side, our results contribute to the literature by suggesting that the shock insulation property of floating exchange rates extends beyond the two countries that have currencies that are free to move. The transmission of shocks between two countries can also be dampened by the choice of floating exchange rates in a third country. On the practical side, our results suggest that, if China did eventually decide to float its currency, Europe's exposure to US shocks would decrease.