In the monetary small open-economy model, a flexible exchange rate insulates the domestic price level from

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In the monetary small open-economy model, a flexible exchange rate insulates the domestic price level from nominal shocks from abroad, but not from real shocks from abroad. Real shocks, such as changes in productivity or technology, affect the relative prices between domestic and foreign goods, which in turn affects the exchange rate and the trade balance. On the other hand, nominal shocks, such as changes in foreign interest rates or prices, directly affect the exchange rate and therefore the prices of imported goods, but not the relative prices between domestic and foreign goods. Therefore, a flexible exchange rate can buffer the economy from nominal shocks but not from real shocks.

In the Monetary Small Open-Economy Model, a Flexible Exchange Rate