Monetary trilemma, dilemma, or something in between?

Published date01 August 2020
DOIhttp://doi.org/10.1111/infi.12363
AuthorRamkishen S. Rajan,Ruijie Cheng
Date01 August 2020
International Finance. 2020;23:257276. wileyonlinelibrary.com/journal/infi © 2019 John Wiley & Sons Ltd
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257
DOI: 10.1111/infi.12363
ORIGINAL ARTICLE
Monetary trilemma, dilemma, or something in
between?
Ruijie Cheng
|
Ramkishen S. Rajan
Lee Kuan Yew School of Public Policy,
National University of Singapore,
Singapore, Singapore
Correspondence
Lee Kuan Yew School of Public Policy,
National University of Singapore, 469A
Bukit Timah Road, Level 10, Tower Block
#1001C, Singapore 259770.
Email: spprsraj@nus.edu.sg
Funding information
Lee Kuan Yew School of Public Policy,
National University of Singapore, Grant/
Award Number: Special Project Funding
Scheme
Abstract
This paper revisits the monetary trilemmaversus
dilemmadebate by examining empirically interest
rate policy independence for a large sample of both
advanced and developing countries over the period
19732014. We broadly concur with the growing body of
literature that suggests that the trilemma still holds,
emphasizing the important insulating effects afforded by
exchangerate flexibility. However, as with Han and Wei
(2018), we also document the existence of an asym-
metric pattern or 2.5lemma between the trilemma and
dilemma; though, in contrast to them, we find there
seems to be evidence of a fear of capital reversalrather
than a fear of appreciation.We further find that
holding higher levels of foreign reserves may help
countries regain a degree of monetarypolicy autonomy.
KEYWORDS
asymmetry, capital controls, dilemma, exchangerate regime, trilemma
1
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INTRODUCTION
For many economies, largescale crossborder capital flows have been a doubleedged sword.
Since the 1990s, debates have been centered on whether global capital mobility is welfare
enhancing or whether it has imparted greater instability to the national economy and
complicated macroeconomic management (Ostry, Ghosh, Chamon, & Qureshi, 2012). The
classical monetary trilemmasuggests that if a peripheral small open country wishes to use
monetarypolicy to manage the domestic economy, it will need to forsake a fixed exchangerate
regime (or will eventually be forced to do so via a currency crisis). A number of emerging
market and developing economies (EMDEs hereafter) have, over time, been moving toward
greater exchangerate flexibility (Corbacho & Peiris, 2018; Duttagupta, Fernandez, &
Karacadag, 2005; Rajan, 2012). This reflects, in part, the belief that more flexible exchangerates
afford a small open country a greater degree of monetarypolicy autonomy in responding to
foreign shocks such as surges and sudden stops in capital flows (Friedman, 1953).
1
However, Rey (2015) has challenged the relevance of the trilemma in this era of financial
globalization, declaring that a small open country with an open capital account would
inevitably be affected by the global financial cycle regardless of the exchangerate regime. She
specifically emphasized the role of the VIX level (the Chicago Board Options Exchange
Volatility Index, which is commonly used as an indicator to measure market uncertainty and
risk aversion) as being the key driver of large comovements in asset prices, gross flows, and
bank leverage. In this sense, the trilemma collapses into a dilemma due to the existence of the
common global factor. Therefore, a small open economy can maintain an independent
monetarypolicy if and only if it forsakes capitalaccount openness.
This paper furthers the foregoing debate by investigating interestrate policy independence
for a large sample of 88 countries comprising both advanced economies (AEs hereafter) and
EMDEs over the period 19732014. While this paper builds on earlier studies of this issue (Klein
& Shambaugh, 2015; Obstfeld, Shambaugh, & Taylor, 2005; Shambaugh, 2004), it differs from
them in two substantive ways. First, we take into account possible asymmetries in the manner
in which peripheral countries respond to changes in the basecountry interestrate (Han & Wei,
2018). Second, we explicitly consider the role of reserves in overcoming the constraints in
monetarypolicy autonomy imposed by an open capital account.
The remainder of the paper is organized as follows: Section 2 discusses the methodology and
data. Section 3 presents the baseline results and confirms the findings of earlier studies that the
trilemma seems to still hold and that both the exchangerate system and capital controls matter.
Section 4 extends the earlier findings by considering potential asymmetric responses by small
open countries to an increaseversusadecrease in the base interestrates and presents a partial
dilemma pattern. In particular, we find that peripheral countries tend to follow suit when base
countries raise interestrates independent of the exchangerate regime but not when base
countries loosen their monetarypolicy stance. We interpret this socalled 2.5lemma as being
due possibly to a fear of capital reversalor fear of reserve loss. We then examine this
hypothesis further and find that the 2.5lemma is, in fact, largely driven by the subsample of
countries with low levels of foreign reserves. Section 5 extends the analysis to consider the case
of intermediate exchangerate regimes and capital controls. Section 6 concludes the paper.
2
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METHODOLOGY AND DATA
Following the general approaches by Shambaugh (2004), Obstfeld et al. (2005) and Klein and
Shambaugh (2015), the methodology starts with the simple interestrate parity equation:
RR E E ρ=+( )+
,
it bit it
eit it
,+1 (1)
where
R
it
is the nominal local interestrate for country iat time t.
R
bi
t
is the nominal interest
rate of the basecountry of country iat time t.
E
it
is the log of the current bilateral exchangerate
(domestic price of foreign currency) at time t,
E
it
e
,+
1
is the log of the expected exchangerate next
period at time
t
+
1
. The term in parentheses captures the expected change in the nominal
exchangerate between country iand the basecountry from this period to the next. If investors
258
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CHENG AND RAJAN

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