Blog Post

Blogs review: Navigating the open economy trilemma

What’s at stake: The challenge of managing capital flows in and out of emerging countries and the difficulty of transmitting a uniform monetary stance across EMU countries have generated renewed interest in the possibility of better navigating the Mundell-Fleming “impossible trinity” of fixed rates, free movement of capital and independent monetary policy. While some authors argue that it depicts an unnecessary restrictive view of the world and that the policy space is, in practice, greater than suggested by the trilemma, others argue that it actually paints a much too rosy picture of the ability of monetary authorities to manage an economy in a world subject the global financial cycles.

By: Date: October 7, 2013 European Macroeconomics & GovernanceGlobal Economics & Governance Tags & Topics

What’s at stake: The challenge of managing capital flows in and out of emerging countries and the difficulty of transmitting a uniform monetary stance across EMU countries have generated renewed interest in the possibility of better navigating the Mundell-Fleming “impossible trinity” of fixed rates, free movement of capital and independent monetary policy. While some authors argue that it depicts an unnecessary restrictive view of the world and that the policy space is, in practice, greater than suggested by the trilemma, others argue that it actually paints a much too rosy picture of the ability of monetary authorities to manage an economy in a world subject the global financial cycles.

Recent challenges to the trilemma

Free Exchange writes that although “the impossible trinity” sounds like new-age theology, it simply posits that an economy can choose at most two of these three: free capital flows, a fixed exchange rate and an autonomous monetary policy. An economy open to free movement of capital can keep a fixed exchange rate, for example, only by subjugating monetary-policy goals to its defense – by raising interest rates sharply, say, when capital outflows put downward pressure on the currency. Yet the trilemma also implies that an economy can enjoy both free capital flows and an independent monetary policy, so long as it gives up worrying about its exchange rate.

Source: Joshua Aizenman and Hiro Ito

Michael Klein and Jay Shambaugh write that the financial trilemma has recently been challenged. Some argue that the policy trilemma depicts too restrictive a view of the world. Governments can ’round the corners’ of the triangle representing the policy trilemma with intermediate policies such as softly pegged exchange rates or temporary, narrowly targeted capital controls. Others (see here) attack the policy trilemma from the opposite direction, arguing that it paints too rosy a picture of the ability of monetary authorities to manage an economy.

Menzie Chinn notes that the trilemma has made its appearance several times throughout the latest NBER Summer Institute. In Barry Eichengreen‘s paper on international coordination and crisis management and the Fed, concerns about the balance of payments deficit – implied by attempting to conduct an expansionary monetary policy under fixed exchange rate regime – were noted. In his comments on Eichengreen’s paper, Larry Summers explicitly mentioned the constraints imposed by the trilemma.

Interest pass-through predictions of the trilemma

Michael Klein and Jay Shambaugh write that if the peg was fully credible, the risk premium was constant, and there was no time-variation in capital controls, domestic short-term interest rates should move one to one with that of the base country under pegged exchange rates. In other words, the pass-through to pegs should be unity, while the pass-through to pure floats (non-pegs) should be zero.

John Bluedorn and Christopher Bowdler write that while empirical results suggest that exchange rate pegs are associated with constraints on monetary policy, the stronger predictions from the simplest theory of the trilemma, namely that when capital is mobile pass-through to pegs is unity and pass-through to pure floats (non-pegs) is zero, are generally rejected. The difference in interest rate pass-through across pegs and non-pegs, which measures the constraint from pegging, is significantly smaller than this theoretical benchmark. A number of explanations for deviations from unit pass-through to pegs and zero pass-through to non-pegs have been proposed. Obstfeld, Shambaugh, and Taylor (2005) show that narrow target zones for exchange rates (broadly classified as pegs) can induce less than unit pass-through. At the other end of the spectrum, “fear-of-floating” may partially constrain exchange rates under non-pegs, such that pass-through exceeds zero.

Rounding the corners of the trilemma in a monetary union

Harold James writes that a common criticism of monetary union is that it requires a single monetary policy, that thus becomes “one size fits all” and deprives policy-makers of a policy tool in responding to particular national or regional circumstances. When the EC Committee of Central Bank Governors began to draft the ECB statute, it took the principle of indivisibility and centralization of monetary policy as given. But this was not really justified either historically or in terms of economic fundamentals. Think first of the gold standard. A critical part of the gold standard was that individual national central banks set their own interest rates, with the aim of influencing the direction of capital movements. Incidentally the same differentiation of interest rates also occurred in the early history of the Federal Reserve System, with individual Reserve Banks setting their own discount rates. The Eurozone is now moving to a modern equivalent, driven by a new concern with macro-prudential regulation. Bank collateral requirements are being differentiated in different areas.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

View comments
Read article More on this topic

Blog Post

Uuriintuya Batsaikhan
Pia Hüttl

The benefits and drawbacks of TTIP

What’s at stake: Since the recent leak of documents on TTIP (Transatlantic Trade and Investment Partnership) negotiations, there has been renewed interest in the trade deal. This blog review looks at studies on the estimated impacts of TTIP on growth, labour markets and social conditions. We also summarise its impact on countries outside the deal, and look at the debates surrounding its counterpart, the TPP (Trans-Pacific Partnership).

By: Uuriintuya Batsaikhan and Pia Hüttl Topic: Global Economics & Governance Date: May 23, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Regulation and growth

What’s at stake: A heated debate took place this week on the blogosphere on the link between regulation and growth following an op-ed by John Cochrane claiming the US economy could be five times richer if regulations were scrapped.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: May 16, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The economics of crime and punishment

What’s at stake: The Senate announced this week revisions to a sentencing reform bill – the Sentencing Reform and Corrections Act – that would lower mandatory minimums for some low-level drug crimes.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: May 2, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Understanding HM Treasury’s Brexit analysis

What’s at stake: The UK will hold a referendum on its membership of the EU on June 23rd 2016. Her Majesty’s Treasury released an assessment of the impact of Brexit finding that the economy would be between 3 and 7% smaller in 2030 if the UK left the EU than it would be if it stayed in.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: April 25, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Trade deficits and jobs at the ZLB

What’s at stake: In the populist narrative against globalization, trade deficits are seen as costing jobs. While this mercantilist view of the world is hard to square in normal times, a number of authors have suggested that the intellectual basis for that view is stronger in a liquidity trap.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: April 4, 2016
Read article More by this author

Blog Post

Jérémie Cohen-Setton

The procyclicality of TFP growth

What’s at stake: The argument that total factor productivity (TFP) is procyclical has been getting a lot of airtime over the past few weeks as it was central to understanding the recent controversy over the economic impact of Sanders. But it also speaks to the question of the current TFP slowdown and to the issue of a clean separation between cycles and trends.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance, Global Economics & Governance Date: March 29, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The trade-backlash explanation of Trump & Sanders

What’s at stake: The success of presidential candidates Donald Trump and Bernie Sanders has had bloggers wondered whether the backlash against globalization is eventually getting political traction.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: March 21, 2016
Read article More on this topic

Blog Post

Pia Hüttl
Alvaro Leandro

Helicopter drops reloaded

What’s at stake: Central banks have recently been scaling up their unconventional monetary policy measures. Discussions about helicopter money seem to be getting ever louder. We review the theoretical discussions, the effectiveness of tax-rebates and legal and political complications

By: Pia Hüttl and Alvaro Leandro Topic: European Macroeconomics & Governance Date: March 14, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The elimination of high denomination notes

What’s at stake: As high-denomination notes (HDNs) make it easier to transact crime, finance terrorism, and evade taxes, a number of commentators have called for their elimination.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: March 7, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The Sanders controversy

What’s at stake: A recent study claiming that Sanders policies would produce 5.3 percent growth a year over the next decade has been at the center of this week’s discussions in the blogosphere.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: February 29, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The impotency of central banks

What’s at stake: The negative market reaction to the latest efforts to provide further monetary stimulus has generated an important discussion on whether central banks have lost credibility in their abilities to fight downside risks and shore up economies.

By: Jérémie Cohen-Setton Topic: Global Economics & Governance Date: February 22, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Blaming the Fed for the Great Recession

What’s at stake: Following an article in the New York Times by David Beckworth and Ramesh Ponnuru, the conversation on the blogosphere was dominated this week by the question of whether the Fed actually caused the Great Recession. While not mainstream, this narrative recently received a boost as Ted Cruz, a Republican candidate for the White House, championed it.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: February 1, 2016
Load more posts