Global liquidity and monetary policy autonomy: an examination of open-economy policy constraints

Abstract

This paper examines the monetary policy constraints facing economies on a fixed peg or managed float regime, contrasting the Mundell-Fleming Trilemma view against the Compensation view commonly found at central banks. While the former holds that foreign exchange inflows and outflows affect the domestic money base and constrain monetary policy under non-floating regimes unless capital controls are adopted, the latter purports that endogenous sterilisation of foreign exchange flows invalidates this trade-off. The predictions of both theories are empirically evaluated for five East Asian economies using central bank balance sheets, vector error correction models and impulse response functions. The findings indicate that the dynamics for the economies studied correspond more closely to the Compensation view than the Trilemma view, suggesting that it is a sustained loss of foreign exchange reserves, not the adoption of a non-floating exchange rate regime, that imposes a relevant constraint on autonomy.