Monetary policy trilemma, inflation targeting and global financial crisis

• Author: Erdal Özmen,Eda Gülşen
• Date: 01 April 2020
• Published date: 01 April 2020
• DOI: http://doi.org/10.1002/ijfe.1752

RESEARCH ARTICLE

Monetary policy trilemma, inflation targeting and global

financial crisis

Eda Gülşen

1

| Erdal Özmen

2

1

Central Bank of the Republic of Turkey,

Research and Monetary Policy

Department, Ankara, Turkey

2

Middle East Technical University,

Department of Economics, Ankara,

Turkey

Correspondence

Erdal Özmen, Middle East Technical

University, Department of Economics.

Ankara, Turkey.

Email: ozmen@metu.edu.tr

Abstract

We empirically investigate the validity of the monetary policy trilemma postu-

lation for emerging market (EME) and advanced (AE) economies under differ-

ent exchange rate and monetary policy regimes before and after the recent

global financial crisis (GFC). Consistent with the dilemma proposition, domes-

tic interest rates are determined by global financial conditions and the FED rate

even under floating exchange rate regimes (ERR) in the long‐run. The impact

of the FED rates is higher in EME than AE and EME are much more sensitive

to global financial cycle under managed than floating ERR. The spillover from

the FED rate substantially increases after the GFC in EME with floating ERR

and AE. The results from the monetary policy reaction functions based on equi-

librium correction mechanism specifications suggest that domestic interest

rates respond to inflation and output gaps especially under inflation targeting

(IT) in the short‐run. The response to inflation gap tends to be smaller in IT

AE after the GFC.

KEYWORDS

Exchange rate regimes, global financial crisis, inflation targeting, monetary policy, policy trilemma

JEL CLASSIFICATION

E50; E52; F30; F33; F42; F65

1|INTRODUCTION

According to the Mundell–Fleming impossible trinity

(trilemma), countries cannot implement an independent

monetary policy towards domestic goals in the presence

of a fixed exchange rate regime (ERR) under free capital

mobility. The recent studies, on the other hand, often find

that an independent monetary policy is not feasible for a

financially integrated economy even under a flexible

ERR. Rey (2015, p.3), for instance, argues that, for small

open economies, under the emergence of a global finan-

cial cycle, “independent monetary policies are possible if

and only if the capital account is managed, directly or

indirectly via macroprudential policies”. Consequently,

instead of trilemma, these countries face with a dilemma

between independent monetary policy and free capital

mobility. Rey (2016) finds that the dilemma is the case

also for inflation targeting (IT) countries with large finan-

cial markets and flexible ERR. The main findings of Rey

(2015, 2016) are supported by Edwards (2015), Hofmann

and Takáts (2015), Taylor (2013, 2016) and Caputo and

Herrera (2017). In contrast, Aizenman, Chinn, & Ito,

2016; Bekaert & Mehl, 2017; Klein & Shambaugh, 2015

are among the recent studies reporting evidence

supporting the trilemma postulation.

Global financial and monetary conditions are amongst

the important determinants of borrowing costs

(Gonzalez‐Rozada & Levy‐Yeyati, 2008; Özatay, Özmen,

& Sahinbeyoglu, 2009) and thus growth (Erdem &

Özmen, 2015; Kose, Otrok, & Prasad, 2012) in emerging

Received: 27 November 2017 Revised: 22 October 2018 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1752

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