Abstract
This paper investigates the potential impacts of the degree of divergence in open macroeconomic policies in the context of the trilemma hypothesis. Using an index that measures the extent of policy divergence among the three trilemma policy choices—monetary independence, exchange rate stability, and financial openness—we find that emerging market economies have adopted trilemma policy combinations with the smallest degree of policy divergence in the last 15 years. We then investigate whether and to what extent the degree of open macro policy convergence affects the probability of a crisis and find that a developing or emerging market economy with a higher degree of policy divergence is more likely to experience a currency or debt crisis. We also compare the development of trilemma policies around the crisis period for the groups of Latin American crisis countries in the 1980s and the Asian crisis countries in the 1990s. We find that Latin American crisis countries tended to close their capital accounts in the aftermath of a crisis, while that is not the case for the Asian crisis countries. The Asian crisis countries tended to reduce the degree of policy divergence in the aftermath of the crisis, which possibly meant they decided to adopt open macro policies that made their economies less prone to a crisis.
Highlights
Managing policies amid economic turbulence is never an easy task, especially when the world economy is highly integrated and markets are intertwined
Exchange rate stability can be more destabilizing if paired with financial openness, while it can be stabilizing if paired with greater monetary autonomy
We have examined the impact of open macro policies on the economies from the perspective of the powerful hypothesis of the trilemma—an economy may not simultaneously pursue full achievement of all three policy goals of monetary independence, exchange rate stability, and financial openness
Summary
Managing policies amid economic turbulence is never an easy task, especially when the world economy is highly integrated and markets are intertwined. Some countries implement partial financial integration while trying to retain control over exchange rate movement and preserving monetary policy autonomy This sort of clustering of the three policies inside the trilemma triangle, or the “middle-ground convergence,” has been characteristic of emerging market economies (EMGs in this paper) in recent decades as observed by Aizenman, Chinn, and Ito (2012). When we think about the history of international monetary systems, countries anecdotally have tended to adopt monetary regimes prevalent in other countries, making the types of monetary regimes across countries correlated with each other Such correlated behavior can be global as in the case of the gold standard in the pre-World War II era or the Bretton Woods system, regional as in the euro system, or clustered around similar income levels as evidenced by the recent middle-ground convergence observed among emerging market economies. Not just for currency crisis, and for banking or debt crisis, how the three trilemma policies are coordinated by individual countries and where they stand in the global context can be important factors
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