The Role of the Exchange Rate as a Shock Absorber in a Small Open Economy

This paper analyses interactions between the real exchange rate and business cycles in a small open economy like Norway. Using a structural vector autoregression model, the role of different shocks are analysed, to investigate to what extent the real exchange rate is absorbing shocks, or a source of shocks itself. The results are ambiguous. Output and the real exchange rate are mainly explained by separate shocks, so that relinquishing exchange rate independence should come at little cost. However, the importance of nominal shocks in the business cycle emphasises that stabilisation is possible. Hence, remaining monetary independence may be attractive.