Exchange rate insulation revisited

We confront the notion that flexible rates insulate countries from external disturbances with new evidence for the euro area and 20 of its neighbors. First, we verify that the exchange-rate disconnect puzzle holds in our sample: When countries let their currencies float against the euro, exchange rates are on average much more volatile than when they peg, but their business cycle is no different suggesting lack of insulation. Second, in response to euro-area monetary-policy shocks output reacts also similarly across exchange-rate regimes, seemingly consistent with the disconnect. Yet, bilateral euro exchange rates hardly respond to these shocks while domestic monetary policy tightens, independently of the exchange-rate regime. Conditional on euro-area shocks, lack of insulation thus correlates with a distinct policy response, not with the disconnect. This evidence challenges theory: we show that state-of-the-art models calibrated to account for the disconnect cannot predict lack of insulation under standard monetary policy rules.