Exchange rate flexibility, the real exchange rate, and adjustment to terms-of-trade shocks

We study the impact of exogenous terms-of-trade shocks in a large sample of small open economies. Using a panel vector autoregression, we estimate the response of domestic variables including the exchange rate, output, exports, imports, and domestic demand, allowing impulse responses to vary according to the de facto exchange rate regime. We find strong evidence that flexible exchange rate regimes play a shock-absorbing role by reducing the response of output to terms-of-trade shocks. Results show that flexible regimes see a stronger response of the real exchange rate and faster external adjustment, suggestive of a mechanism that switches expenditure from imported to domestically-produced goods.