Emerging markets and developing economies (EMDEs) are vulnerable to external shocks. In the literature, it is well-documented that financial frictions are the key sources of this vulnerability. Using panel data of 17 countries, this paper shows that the impact of global risk-off shocks is larger for the economies with shallower financial markets. With the estimated Integrated policy framework (IPF), it argues that FX intervention (FXI) and macro-prudential measure (MPM) are needed in addition to the conventional interest rate policy to address external shocks. The key contributions of the paper are the followings.

① A new measure for market depth is provided. It is empirically measured as the responsiveness of uncovered interest parity (UIP) premium to the global risk-off shock. This measure summarizes inefficiencies due to financial frictions in domestic financial market and FX market. 

② Using panel dataset composed of 17 countries, it is empirically shown that when global risk-off shock hits, (i) domestic currency depreciates more; and (ii) domestic credit condition becomes tighter in the countries with shallow markets. 

③ To incorporate this empirical finding in a DSGE model, the paper builds on the IPF framework à la Linde et al. (2024) and assume that global risk-off shock induces not only capital outflows but also spikes in domestic credit spreads. It is shown that the shallower the market, the more contractionary the effect.

④ The model is estimated to reflect the Korean economy to show that it is welfare-improving to implement FXI and MPP together with the conventional interest rate policy to insure the economy against the shock.