Can Central Banks circumvent the impossible trinity within their operational frameworks? Theory and evidence

Abstract

AbstractCentral Bank operational frameworks can be challenged during times of severe financial stress. Typical of such an instance is where policymakers attempt to heavily manage or fix a domestic exchange rate whilst faced with balance of payments pressures. However, it is claimed to be impossible for policymakers to achieve both monetary independence and exchange rate stability if the domestic economy were to post a balance of payment surplus, otherwise known as the ‘impossible trinity’. The purpose of this paper is to investigate the European Monetary System crisis through the lens of Institutional Practice, that is the day‐to‐day operations of key institutions, such as the Central Bank, Treasury and commercial banks, with a view to demonstrate why global imbalances are able to occur and persist across the international monetary system. Through both a theoretical and an empirical appraisal, this paper shows how Central Banks in economies with a balance of payments surplus can circumvent the binding constraints of the trinity within their operational frameworks.