Monetary Policy, Exchange Rate and Capital Flow from 'Equilateral Triangle' to 'Scalene Triangle'

Abstract

The Chinese version of this paper can be found at: http://ssrn.com/abstract=2949313. The traditional “Impossible Trinity” is an equilateral triangle. But since 2008, importance of capital flow has been greatly elevated, and equilateral triangle has transformed into scalene triangle. We first in the literature propose the “Scalene Impossible Trinity”, which is a more general analytical framework about “Impossible Trinity”. We also establish a theoretical model, and with the premise of “Scalene Impossible Trinity”, calculate the optimal level of macro-prudential management regarding cross-border capital flow and optimal level of international monetary policy coordination within different foreign exchange rate regimes. Our proof shows that even if foreign exchange rate could float freely, the central bank should conduct a certain level of macro-prudential management of cross-border capital flow. Based on this model and recent practices of The People’s Bank of China, we also present the New Macro-Financial Policy Framework (New MFPF), which is “Macro-prudential management plus Exchange rate flexibility plus International monetary policy coordination.” Only by adopting this three-pronged strategy, the central bank could attain macroeconomic equilibrium.