This paper investigates the hypothesis that in a small open economy flexible exchange rates act as a ‘shock absorber’ and mitigate the effects of external shocks more effectively than fixed exchange rate regimes. Using a sample of 42 developing countries, the paper assesses whether the responses of real GDP, the trade balance and the real exchange rate to world output and world real interest rate shocks differ across exchange rate regimes. The paper shows that there are significant differences in the variability of macroeconomic aggregates under fixed and flexible exchange rate regimes.
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