The open economy trilemma in Latin America: A three‐decade analysis

• Author: Igor da Silva Veiga,Helder Ferreira de Mendonça
• DOI: http://doi.org/10.1111/infi.12109
• Date: 01 June 2017
• Published date: 01 June 2017

DOI: 10.1111/infi.12109

ARTICLE

The open economy trilemma in Latin America:

A three-decade analysis

Helder Ferreira de Mendonça

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Igor da Silva Veiga

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Department of Economics, Fluminense

Federal University, Miguel Pereira, Rio

de Janeiro, Brazil

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Department of Economics, Fluminense

Federal University, Jardim Botânico, Rio

de Janeiro, Brazil

Correspondence

Helder Ferreira de Mendonça,

Department of Economics, Fluminense

Federal University, Rua Dr. Sodré, 59,

Vila Suíça, Miguel Pereira, Rio de

Janeiro, 26900-000, Brazil.

Email: helderfm@hotmail.com

Abstract

This studyconcerns the open economy trilemmain emerging

economies, and uses a panel data framework to investigate

cross-dependence among the countries and respective

parameters of the 23 countries in Latin America from

1980 to 2010. We examinethe impact that trilemma choices

impose on economic performance (output volatility and

inflation), as well as whether the adoption of inflation

targeting influences the results. The findings indicate that

promotingexchange rate stability and financial openness are

efficient strategiesfor improving the economic performance

of Latin America economies. Furthermore, the adoption of

inflation targetingenhances the effects of financial openness

on output volatility.

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INTRODUCTION

In recent decades, one of the main challenges for macroeconomic policy has been simultaneously managing

interest rates, exchange rates, and capital account mobility. The phenomenon known in the economic

literature as the open economy trilemma (hereafter trilemma)orimpossible trinity (inconsistent trinity)

describes the inability of the monetary authority to achieve simultaneously three goals in an open economy:

perfect capital mobility, a fixed exchange rate, and independence of monetary policy.

The financial liberalization witnessed recently in developing economies has changed the way in

which these countries address the trade-offs of the trilemma. According to Aizenman and Ito (2014),

because these economies look to figure prominently in international capital flows and therefore must

tolerate lower capital controls, the main changes to be adopted in terms of the trilemma configuration

are reduced to two options: relatively stable exchange rate (and thus relinquish the independence of

monetary policy); or relatively high monetary independence (entailing less exchange rate stability).

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International Finance. 2017;20:135–154. wileyonlinelibrary.com/journal/infi © 2017 John Wiley & Sons Ltd

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Aizenman, Chinn, and Ito (2010) believe the case of developing economies is essential to

understanding the impact of different trilemma configurations on economic performance. They claim

that because these countries have limited financial systems (and are therefore more vulnerable to

external shocks), the analysis of the respective variables (such as output and inflation) becomes

relevant vis-à-vis the different combinations of trilemma objectives. The growing body of research

analyzing the trilemma and its implications for the performance of developing economies is evidence

of the importance of this subject.

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Although several studies have analysed the consequences of trilemma outcomes for emerging

economies, the literature focusing on Latin American countries is still incipient. Hence, seeking to

contribute to the literature on developing economies, this paper looks at the behaviour of the Latin

American economies vis-à-vis trilemma trade-offs for the period 1980–2010. The aim is to analyse

how various configurations of trilemma policy affected the economic performance of Latin American

economies, particularly regarding growth, stability of output, and inflation.

For the Latin American economies, we measure the behaviour of each component of the trilemma

based on indices developed by Aizenman, Chinn, and Ito (2008, 2010).

Although the increasing integration of trade, finance, and technology in recent decades increases

interdependence among the countries, as highlighted by de Hoyos and Sarafidis (2006), most of the

empirical literature on the trilemma fails to address such potential effects and commonalities.

Therefore, seeking to mitigate this problem, we address heterogeneity problems and cross-section

(CD) dependence in the panel data analysis, as proposed by Pesaran (2004).

Another relevant issue is that the spread of inflation targeting in Latin American economies may

have ramifications for the trilemma configurations of these countries. Hence, a novel aspect of this

paper is its analysis of whether—in light of the trilemma configuration—inflation targeting can

influence economic performance.

Latin America serves as an enabling environment for the analysis of the open economy trilemma.

This is a region where a group of developing economies—characterized by high macroeconomic

instability and high exposure to external crises—have undertaken a significant movement towards

financial openness (Reinhart, 2013). Furthermore, in recent years some economies in the region have

adopted inflation targeting. Therefore, we must assess the impact of trilemma choices on economic

performance and examine whether inflation targeting influences the results; indeed, exchange rate

stability and financial openness are important strategies for improving economic performance in the

Latin America economies. The results suggest that the adoption of inflation targeting can enhance the

effects of financial openness on output volatility.

The remainder of this study is organized as follows: Section 2 explores the main

characteristics of relationships among the trilemma, financial liberalization, international

reserves, and inflation targeting in Latin America. Section 3 discusses measurement of the

trilemma, based on the indices of Aizenman et al. (2008, 2010). Section 4 presents the

methodology and data used in the study. Section 5 looks at the empirical evidence—gained from a

panel data analysis of different samples—of trilemma effects on output volatility and inflation.

Section 6 concludes the paper.

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SOME OBSERVATIONS FOR LATIN AMERICA

The early-1990s saw increased financial liberalization, which meant new challenges for the

management of macroeconomic policy vis-à-vis the trilemma. The case of developing economies is

all the more crucial because these economies have limited financial systems, and therefore are more

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DE MENDONÇA AND DA SILVA VEIGA