Independent Monetary Research Articles

Living with the trilemma constraint: Relative trilemma policy divergence, crises, and output losses for developing countries

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 relative policy divergence among the three trilemma policy choices, namely monetary independence, exchange rate stability, and financial openness, we find that emerging market countries have adopted trilemma policy combinations with the least degree of relative policy divergence in the last 15 years. We find that a developing or emerging market country with a higher degree of relative policy divergence is more likely to experience a currency or debt crisis. However, a developing or emerging market country with a higher degree of relative policy divergence tends to experience smaller output losses when it experiences a currency or banking crisis. Latin American crisis countries tended to reduce their financial integration in the aftermath of a crisis, while this is not the case for the Asian crisis countries. The Asian crisis countries tended to reduce the degree of relative policy divergence in the aftermath of the crisis, probably aiming at macroeconomic policies that are less prone to crises. The degree of relative policy divergence is affected by past crisis experiences – countries that experienced currency crisis or a currency-banking twin crisis tend to adopt a policy combination with a smaller degree of policy divergence.

Sortir des politiques monétaires non conventionnelles : quels défis ?

Les politiques monétaires engagées pour répondre à la crise financière ont démontré que modifier les bilans des banques centrales a des conséquences importantes. La nouvelle macroéconomie classique, qui a gagné en influence depuis la fin des années 1980 et qui a conduit à se concentrer exclusivement sur le taux directeur, avait simplement ignoré de tels effets (équivalence ricardienne). Ramener les bilans des banques centrales à des niveaux normaux est important pour parvenir à préserver les marges de manœuvres politiques et constituera un formidable défi. Cette tâche nécessitera la coopération de la banque centrale avec le Trésor sans sacrifier son indépendance en matière de politique monétaire. Alors que les banques centrales doivent surveiller la résilience des marchés avec pragmatisme, elles ne doivent pas tomber dans le piège de la domination financière.Classification JEL : E42, E52, E58.

Does the policy trilemma still hold? Fresh evidence and its implications

Economic success of any nation intrinsically hinges on the tradeoff between external policy choices and their internal consequences. An enduring challenge that countries confront is the ‘trilemma’ of choices between three desirable, yet jointly unattainable objectives of maintaining a fixed exchange rate regime, unfettered cross-border capital flows and monetary policy independence. This study examines the extent of monetary autonomy for over 130 nations spanning the period 1999–2011. Using both pooled cross-sectional as well as time series analyses I find more loss of monetary sovereignty for fixed regimes than non-fixed ones, supporting the trilemma's predictions. However, I do note this difference is only marginal and several floaters exhibit ‘fear of floating’ behaviour allowing sufficient transmission of foreign interest rates. Finally, I examine the macroeconomic consequences of the three tenets of the trilemma. I find higher monetary independence, greater capital openness as well as greater regime flexibility to promote economic stability.

The Bank of England, Montagu Norman and the internationalisation of Anglo-Irish monetary relations, 1922–1943

The granting of a £7,000m bilateral loan by the British government to the Republic of Ireland in October 2010 highlights the banking co-dependence of modern Anglo-Irish relations. This article provides a Bank-of-England-centred perspective on the development of Irish monetary institutions from the granting of Irish monetary independence in December 1921 to the establishment of the Central Bank of Ireland in 1943. Irrespective of unresolved Anglo-Irish political issues, the Bank of England's Irish policy during this period was based on a strict adherence to Montagu Norman's key central banking principles of co-operation, exclusiveness and political autonomy. This article identifies that the application of these principles survived both the coming to power of Fianna Fáil (Soldiers of Destiny) in Southern Ireland in 1932 and the outbreak of war in 1939. This article also argues that Norman's adherence to a wider internationalist view of monetary relations played an important role in forcing the overwhelmingly Protestant and pro-union Irish commercial banks, headed by the Bank of Ireland, to come to terms with the reality of Irish monetary independence. In this context, Norman's approach to Southern Ireland parallels the transition from Empire to Commonwealth, which began to emerge in the interwar period.

The Impact of the Monetary Policy on the Economic Growth and the Development of the Republic of Macedonia

Upon the monetary independence of the country from the previous joined state, it began with the creation (construction) of new own monetary system and implement its own authentic monetary policy. Besides the implementation of the projected primary monetary objectives (maintenance of price stability and stability of the purchasing power of money, i.e. internal and external value of the denar), the monetary authority cares for the realization of other basic goals of macroeconomic policy, such as: providing a higher rate of economic growth, increased foreign trade, especially exports, increasing the employment and improving the balance of payments positions. The realization of these macroeconomic objectives is possible if, with the measures of macroeconomic policy, and in this framework, monetary policy measures, are created the: favorable conditions for management(expansion of production capabilities, better utilization of available resources, adequate location and prompt reallocation of resources), improving economic relations and trade cooperation, aimed at increasing foreign trade, especially exports and improve the current account positions, and thus the position of the balance of payments. DOI: 10.5901/mjss.2013.v4n11p770

The “Impossible Trinity” Hypothesis in an Era of Global Imbalances: Measurement and Testing

AbstractWe outline new metrics for measuring the trilemma aspects: exchange rate flexibility, monetary independence, and capital account openness, taking into account substantial international reserve accumulation that has taken place since the 2000s. Since 1990, the trilemma variables in emerging markets have converged towards intermediate levels, characterizing by managed flexibility, using sizable international reserves as a buffer while retaining some degree of monetary autonomy. We test the linearity of the trilemma, and find that the weighted sum of the three trilemma variables adds up to a constant. Thus, a rise in one trilemma variable should be traded‐off with a drop of the weighted sum of the other two.

The Financial Crisis, Rethinking of the Global Financial Architecture, and the Trilemma

This paper extends our previous paper (Aizenman, Chinn, and Ito 2008) and explores some of the unexplored questions. First, we examine the channels through which the trilemma policy configurations affect output volatility. Secondly, we investigate how trilemma policy configurations affect the output performance of the economies under severe crisis situations. Thirdly, we look into how trilemma configurations have evolved in the aftermath of economic crises in the past. We find that trilemma policy configurations and external finances affect output volatility mainly through the investment channel. While a higher degree of exchange rate stability could stabilize the real exchange rate movement, it could also make investment volatile, though the volatility-enhancing effect of exchange rate stability on investment can be cancelled by holding higher levels of international reserves (IR). Greater financial openness helps reduce real exchange rate volatility. These results indicate that policymakers in a more open economy would prefer pursuing greater exchange rate stability and greater financial openness while holding a massive amount of IR. We also find that the “crisis economies” could end up with smaller output losses if they entered the crisis situation with more stable exchange rates or if they continue to hold a high level of IR and maintain greater exchange rate stability during the crisis period. Lastly, we find that developing countries are often found to have decreased the level of monetary independence and financial openness, but increased the level of exchange rate stability in the aftermath of a crisis, especially for the last two decades. This finding indicates how vulnerable developing countries, especially emerging market ones, are to volatile capital flows as a result of global financial liberalization.

Turkey’ Trilemma Trade-offs: Is there a role for reserves?

In this paper, we study the trilemma configuration of the Turkish economy. The paper starts by empirically testing the Mundell-Fleming theoretical concept of an “impossible trinity” (trilemma) for Turkey, following the Aizenman, Chinn and Ito (ACI) approach. This includes calculating the trilemma indices and investigating their evolution over the period of 1998Q1-2010Q4, which is split into three sub-samples according to the Turkey’s macroeconomic policies. We also introduce alternative empirical techniques in order to deal with possible misspecification problems detected in the ACI approach. These techniques include employing additional terms in the regression, Two Stage Least Squares, General Method of Moments and Kalman filtering. The analysis supports the conclusion that the trilemma trade-offs are binding for Turkey for each sub-period. Besides, it shows how contributions of financial integration and monetary independence have increased from the first period to the last, with corresponding limitations on exchange rate stability. The analysis continues by exploring the implications of changes in the trilemma indices for macroeconomic outcomes. Accordingly, it reveals evidence that financial integration and monetary autonomy together with corresponding loss of exchange rate stability have impacts on growth volatility, inflation and inflation volatility throughout 1998-2010, though these effects might differ for each sub-period. Finally, it finds that there is a key role for raising international reserves as trilemma trade-offs and their effects on macroeconomic variables have been mitigated with their accumulation

The Effectiveness of Central Bank Independence vs. Policy Rules

This paper assesses the relative effectiveness of central bank independence vs. policy rules for the policy instruments in bringing about good economic performance. It examines historical changes in (1) macroeconomic performance, (2) the adherence to rules-based monetary policy, and (3) the degree of central bank independence. Macroeconomic performance is defined in terms of both price stability and output stability. Both de jure and de facto central bank independence at the Federal Reserve are considered. The main finding is that changes in macroeconomic performance during the past half century were closely associated with changes in the adherence to rules-based monetary policy and in the degree of de facto monetary independence at the Federal Reserve. But changes in economic performance were not associated with changes in de jure central bank independence. Formal central bank independence alone has not generated good monetary policy outcomes. A rules-based framework is essential.

ALL ECONOMIC FREEDOM IS NOT CREATED EQUAL: EVIDENCE FROM A GRAVITY MODEL

This article analyzes the differential impacts of different types of economic freedom on bilateral trade flows between the United States and 122 countries over 10 years. A gravity model of trade is employed to investigate how various freedom indices assembled by the Fraser Institute impact the volume of trade, exports, and imports. The main findings of the article are that each of the freedom indices impact heterogeneously across the measure of trade flows, with the changes in Regulation having the biggest impact on trade. All combinations of freedom are used to find the mixture of freedom which yields the largest trade gains. The largest gains from trade generally combine Business Regulation in a variety of different configurations. The smallest gains, or losses, to trade arise with augmented monetary independence. (JEL D02, F14, F55)

The Current Economic Crisis of the EU: Genesis, Analysis and Solutions

Abstract The article approaches the current economic crisis from an historical perspective, analyzing the building of the monetary integration and the common currency. The process is explained through pointing out its effects on the European integration and outlining the positive and negative consequences of the introduction of a common currency in the European Union. The investigation continues with a general outlook of the current situation of the countries which were more affected by the current crisis-Greece, Ireland, Portugal, Spain, Italy and Cyprus. What all these countries have in common is the necessity of extra funding in a context of austerity, plus some national particularities. The author proposes an expansion in the public spending as the only reliable way to stimulate European economies in the crisis. As the introduction of the euro meant the end of the monetary independence for the Member States, an innovative solution is proposed-the creation of an Economic Government in the union in order to transfer funds from wealthier states to the countries in trouble. It is presented as a necessity for the states in crisis, a necessity for the wealthier states, and a must for the European Union.

Financial Trilemma in China and a Comparative Analysis with India

AbstractA key challenge facing most emerging market economies today is how to simultaneously maintain monetary independence, exchange rate stability and financial integration subject to the constraints imposed by the trilemma, in an era of widespread globalization. In this paper we review and contrast the trilemma policy choices and trade‐offs faced by the two key drivers of global economic growth: China and India. China's trilemma configurations are unique relative to other emerging markets in terms of the predominance of exchange rate stability, and in the failure of the trilemma regression to capture a consistently significant role for financial integration. In contrast, the trilemma configurations of India are in line with choices made by other emerging countries. Over time, India, like other emerging economies, has converged towards a middle ground among the three policy objectives, and has achieved comparable levels of exchange rate stability and financial integration buffered by sizeable international reserves.

Sterilisation and Monetary Control by the GCC Member Countries

AbstractThe prevailing dollar peg of the Gulf Cooperation Council (GCC) countries and the absence of any significant current and capital account restrictions led some to believe that these countries have lost monetary independence. However, the paper presents evidence that interest rates of the GCC countries did not converge to the interest rates of the US implying that the assets of the GCC countries are not perfect substitutes to the US assets. This imperfect asset substitutability has allowed the GCC countries to manoeuvre their monetary policies and the central banks of the GCC countries have had some control over their money growth rates by sterilising the changes in international reserves. Results indicate that the monetary authorities of these countries used domestic credit policy to attain some domestic policy objective while engaging in sterilised foreign exchange intervention. This result implies that the proposed GCC central bank should be able to maintain the monetary independence as a group and can reap the benefit of monetary efficiency of the proposed Gulf Monetary Union.

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Are capital controls in the foreign exchange market effective?

One of the reasons for governments to employ capital controls is to obtain some degree of monetary independence. In this paper we test whether capital controls can reduce the link between exchange rates fluctuations and cross border interest differentials. Recent capital control proxies are used in order to determine the date of capital account liberalization for a panel of Western European and emerging countries. Results show that capital controls have a very limited effect on observed deviations from interest parities, even when accounting for the political risk associated with capital controls.

Effects of the trilemma policies on inflation, growth and volatility in Norway

This paper finds support for the trilemma for Norway, suggesting that the three trilemma policies – exchange rate stability, monetary independence and financial integration – have a tradeoff. Although the policy combination of exchange rate stability and monetary independence was dominant in 2010, the other two policy combinations were also prevalent in recent years. There has been a converging trend among the three trilemma policy combinations. Norway chooses a middle ground approach as represented by a managed float with adequate foreign reserves to back up, moderate monetary autonomy, and medium level of financial integration. More exchange rate stability has a positive impact on the growth rate, and more financial integration causes the inflation rate and inflation volatility to decline. More monetary independence does not affect inflation, growth and volatility.

Optimal Fiscal Action in an Economy with Sovereign Premia and Without Monetary Independence: An Application to Italy

We welfare rank various tax-spending policies. The setup is a New Keynesian model of a semi-small open economy featuring sovereign risk premia and loss of monetary policy independence. The model is calibrated to match data from the Italian economy 2001-2011. We compute various optimized state-contingent tax-spending policy rules when the policy aim is shock stabilization and/or debt consolidation.

Testing the trilemma: exchange rate regimes, capital mobility, and monetary independence

Previous research on the incompatibility of a pegged exchange rate, capital mobility, and monetary independence (the open-economy trilemma), based on the degree to which domestic interest rates follow foreign rates, has produced mixed results. Despite its centrality to other areas of investigation, such as currency crises, the role of the credibility of the peg has hitherto been ignored. Fluctuations in perceived devaluation probabilities will move domestic interest rates, given foreign interest rates, even if countries have no genuine monetary independence. Using data for 126 countries from 1990, it is shown that countries on credible pegs without capital controls follow foreign interest rates closely, and that the hypothesis of complete lack of monetary independence cannot be rejected in this case. Our findings are robust to alternative measures of credibility (inflation differentials; types of peg), and to different ways of classifying exchange rate regimes and identifying capital controls.

The 'Impossible Trinity' Hypothesis in an Era of Global Imbalances: Measurement and Testing

We outline new metrics for measuring the trilemma aspects: exchange rate flexibility, monetary independence, and capital account openness, taking into account recent substantial international reserve accumulation. Since 1990, the trilemma variables in emerging markets have converged towards intermediate levels, characterizing by managed flexibility, using sizable international reserves as a buffer while retaining some degree of monetary autonomy. We test the linearity of the trilemma, and find that the weighted sum of the three trilemma variables adds up to a constant. Thus, a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two.

Trilemma policy convergence patterns and output volatility

We examine the development of open macroeconomic policy choices among developing economies from the perspective of the powerful “trilemma” hypothesis. We construct an index of divergence of the three trilemma policy choices, and evaluate its patterns in recent decades. We find that the three dimensions of the trilemma configurations are converging toward a “middle ground” among emerging market economies, equipped with managed exchange rate flexibility, underpinned by sizable holdings of international reserves, and intermediate levels of monetary independence and financial integration. We also find emerging market economies with more converged policy choices tend to experience smaller output volatility in the last two decades. Emerging markets with relatively low international reserves/GDP could experience higher levels of output volatility when they choose a policy combination with a greater degree of policy divergence while this heightened output volatility effect does not apply to economies with relatively high international reserves/GDP holding.