Abstract
Simultaneous making policy of interest rates, exchange rates and capital accounts can be extended to trilemma theory, contrary to its earlier theories, provided that the imbalances of the private sector, the government and the capital account adjusted through the policy variables such as the government expenditures, the interest rates on domestic deposits, the interest rates on domestic loans, effective exchange rates, foreign prices and foreign interest rates. On the other hand, the components of the extension of trilemma theory in the form of internal and external imbalances affect the exchange rate. In other words, if the real sector markets of the economy are not cleared through the aforementioned trilemma components, and policy variables, internal and external imbalances will be affected by opposite direction of net domestic assets (ΔNDA) and net foreign assets (ΔNFA) of the banking system. This is in accordance with the fundamental principles of the monetary approach balance of payments and exchange rate. Policy variables do not put pressure on the unofficial exchange rate as long as they have the same effect on the net changes in the domestic and foreign assets of the banking system. The purpose of this study is to consider the effect of internal and external imbalances on exchange rate through the simultaneous equations system, generating impulses in policy variables, and examining reactions in Iranian economy. In this paper, the monetary exchange rate determination model is analyzed and examined by using the extension of trilemma theory for macroeconomic data of Iran in the form of internal and external imbalances. The results of this study suggest that policy variables can stabilize the unofficial exchange rate (with other conditions being constant) through trading off internal and external imbalances. Thus, the economic policymaker can, while independently policing interest rates, capital accounts and government expenditures and other policy variables in this research, maintain exchange rate stability as a strategic variable and anchor the general level of prices.
Highlights
The impossibility of simultaneously policing of the exchange rate, the capital account, and the interest rate in a small economy is called Trilemma theory
Concluding Remarks The main purpose of this paper is to provide a theoretical framework for examination of the relationship between internal and external imbalances and the unofficial exchange rate
This paper shows that the policy variables affecting the real economy components so that internal and external imbalances have moderated each other, it is possible to avoid high volatility of the exchange rate as one of the key elements of the trilemma theory
Summary
The impossibility of simultaneously policing of the exchange rate, the capital account, and the interest rate in a small economy is called Trilemma theory. Assuming that policymaking for each of the aforementioned variables in the small assumed economy does not affect other countries (in case of being ceteris paribus), the key question is how the transitional mechanism of internal and external imbalances in the real and monetary sectors will effect on the exchange rate? The lack of sufficient foreign exchange reserves to balance the real and the monetary sectors on the one hand and the simultaneous policing of exchange rate, interest rate and capital account variables in a small country with an open economy on the other hand is a clear reason for creating balance of payments and foreign exchange crises (Krugman, 1979). The mechanism of the transition of internal and external imbalances to the foreign exchange sector through the system of simultaneous equations is examined in the context of the extension of trilemma theory. Since exchange rate stabilization is important in some small economies as an anchor of price, any variable influencing exchange rate stabilization is important (Maurice, 2005)
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