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We propose a new approach to separately identify domestic and external shocks in small open economies, and find that they cause markedly different exchange rate dynamics. External shocks generate large deviations from uncovered interest parity, while domestic shocks do not. Besides, external shocks strongly comove with global risk aversion and are linked to U.S. economic fluctuations. We present a two-country small open economy model with international asset market imperfections that is consistent with these facts. In our model, global risk aversion shocks drive exchange rate dynamics, and a country's net foreign asset position governs their international transmission. We provide empirical evidence that a country's exposure to external shocks indeed depends on its net foreign asset position.
