DP166 | 'Locomotive' and Other Channels of Transmission under Flexible Exchange Rates

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This paper presents a simple model of the effects of exchange rate flexibility on the transmission of income shocks. The starting point is the traditional channel through exports and imports known as the "locomotive". The intertemporal exchange rate model presented here also allows for the effect of future internal and external shocks on home income. Furthermore, it is shown that exchange rate movements work in the opposite direction to the locomotive effect, so that a foreign boom also causes contemporaneous recessionary pressures in the home economy. The model is simulated in order to assess the relative magnitude of these transmission channels. While the adjusted locomotive channel remains important, the others cannot be neglected, especially if the home country has a negative foreign asset position.