It is often asserted that a flexible exchange rate regime would facilitate current account adjustment. Using data on over 170 countries over the 1971–2005 period, we examine this assertion systematically. We find no strong, robust, or monotonic relationship between exchange rate regime flexibility and the rate of current account reversion, even after accounting for the degree of economic development and trade and capital account openness. This finding presents a challenge to the Friedman (1953) hypothesis and a popular policy recommendation by international financial institutions.

This paper tests if real and financial linkages between countries can explain why movements in the world's largest markets often have such large effects on other financial markets, and how these cross-market linkages have changed over time. It estimates a factor model in which a country's market returns are determined by global, sectoral, and cross-country factors (returns in large financial markets) and by country-specific effects. Then it uses a new data set on bilateral linkages between the world's five largest economies and approximately 40 other markets to decompose the cross-country factor loadings into direct trade flows, competition in third markets, bank lending, and foreign direct investment. In the latter half of the 1990s, bilateral trade flows are large and significant determinants of how shocks are transmitted from large economies to other stock and bond markets. Bilateral foreign investment is usually insignificant. Therefore, despite the recent growth in global financial flows, direct trade still appears to be the most important determinant of how movements in the world's largest markets affect financial markets around the globe.