Monetary Policy Choices of Southern Economies

Abstract

Exchange rate regime choice makes up a decisive part of the so-called impossible trinity that is based on the Mundell Fleming model (Fleming, 1962; Mundell, 1963). The “impossible trinity” states that it is impossible for monetary policy authorities to reach policy autonomy (flexible exchange rates), financial integration (open capital accounts), and exchange rate stability (fixed exchange rates) simultaneously (cf. Frankel, 1999: 7; Macedo et al., 2001: 14; Stiglitz, 2004; Aizenman et al., 2008). A country may achieve only two of these three objectives (therefore also called the policy “trilemma”). Based on the trilemma hypothesis, unilateral monetary policy options of either fully flexible or fully fixed exchange rates were defended for a long time as the only valuable exchange rate regime choices, since financial integration used to be considered the untouchable corner of the impossible trinity of monetary policy choices (Ghosh and Ostry, 2009). Drawing on the assumption of perfect markets, it was assumed that free capital flows, just like free trade, would render the highest aggregate welfare gains. Free capital flows would allow investment to be allocated according to the comparatively highest expected returns (cf. Prasad et al., 2003). Hence, a country could choose between monetary policy autonomy with flexible exchange rates and monetary stability with fixed exchange rates.