Dominant Currency Shocks and Foreign Exchange Pressure in the Periphery

April 7, 2022

Working Paper | This paper assesses the effects of dominant currency shocks (strong US dollar) on emerging markets by studying exchange market pressure (EMP) or foreign exchange (FX) liquidity, GDP growth, external debt, and inflation.

Authors: Aleksandr V. Gevorkyan and Tarron Khemraj

The literature emphasizes inflation pass-through, trade volume and GDP growth contraction in the periphery following a strong dollar. Comparing the dollar shock with euro and commodity price shocks and employing pooled mean group estimates and panel VAR across regimes of trade invoicing, this paper shows that bilateral depreciation can decrease FX liquidity and GDP growth in the periphery, failing to achieve the conventional macroeconomic adjustments of a competitive depreciation. A strong dollar reduces external debt, but strong euro has the opposite effect, implying circumvention of the ‘original sin.’ An EMP, FX liquidity, shock from the periphery appreciates the US dollar, affirming dollar’s safe-haven status. These findings have implications for balance of payments and exchange rate policy management.

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