Exchange Rate Flexibility and the Transmission of Business Cycles

This paper presents a very simple model of the effects of flexible exchange rates in the transmission of business cycles. The starting point is the traditional "locomotive" effect, through exports and imports. Aside from this horizontal transmission, the intertemporal exchange rate model presented here allows for the effect of future internal shocks on home income (horizontal transmission) as well as for the effect of future external shocks on home income (diagonal transmission). These channels highlight the role of flexible rates and follow from an intertemporal constraint on the trade balance. In the presence of foreign-held debt, furthermore, the locomotive effect can be reversed, so that a foreign boom can cause a recession at home. The determinants of the debt ceiling are derived. The model is simulated in the case of two symmetric countries with constant values for the policy variables and the interest rates at home and abroad.