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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.


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The Italian referendum

What’s at stake: on 4 December, Italy will hold a referendum on a proposed constitutional reform approved by Parliament in April. The reform, which was designed in tandem with a new electoral law, aims to overcome Italy’s “perfect bicameralism” by changing the structure and role of the Italian Senate. It also changes the distribution of competences between the state and regions. After the shocks of Brexit and the US election, polls are now drifting towards a defeat of the government’s position in Italy.

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Trumpocalypse now: first reactions

What’s at stake: this question should probably be re-formulated as “what’s NOT at stake?” On Tuesday 8 November, the US elected Donald Trump as its next President. Several aspects of Trump’s political and economic agenda appear extreme (we have previously focused on his stance on trade). After the initial shock, we review economists’ opinions on what has happened and what may happen. We will be coming back to this topic regularly.

By: Silvia Merler Topic: Global Economics & Governance Date: November 21, 2016
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Brexit and the law

What’s at stake: last week, the UK High Court ruled that the triggering of Article 50 - and therefore the Brexit process - should involve the UK Parliament. The Government will appeal the decision but this has created a new wave of uncertainty about the timing of Brexit, and on what this involvement can mean in practice. We review the different opinions.

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Monetary policy at the time of elections

What’s at stake: At this week’s meeting, the Federal Reserve left interest rates unchanged. While this was largely expected, the economic blogosphere has been discussing whether and to what extent this is linked to the election, and what can be expected for the future.

By: Silvia Merler Topic: Global Economics & Governance Date: November 7, 2016
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Should we rethink fiscal policy?

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By: Silvia Merler Topic: Global Economics & Governance Date: October 24, 2016
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Brexit, the pound and the UK current account

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By: Silvia Merler Date: October 17, 2016
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The Deutsche Bank Frenzy and what it says about European banks

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By: Silvia Merler Topic: Finance & Financial Regulation, Global Economics & Governance Date: October 10, 2016
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Trumping Trade

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Big in Japan

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By: Silvia Merler Topic: Global Economics & Governance Date: September 26, 2016
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The US infrastructure investment debate

What’s at stake: Infrastructure investment has been and will continue to be a prominent campaign theme in the run up to the US elections. Both Hillary Clinton and Donald Trump have promised significant public investment in infrastructure. For some time, the discussion has revolved around the opportunities and costs of increased government infrastructure spending.

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The Apple of Discord

What’s at stake: On August 30th, following the results of an in-depth state aid investigation started in 2014, the European Commission concluded that Ireland granted undue tax benefits of up to €13 billion to Apple. The decision is based on state aid grounds: the Commission argues that two tax rulings issued by Ireland effectively granted Apple preferential treatment, which amounted to state aid. The Commission ordered Ireland to recover up to €13 billion (plus interest) from Apple, but the decision is controversial and opinion differ as to the effects it will have. We summarize reactions.

By: Silvia Merler Topic: Innovation & Competition Policy Date: September 12, 2016
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Post-Jackson Hole low morale

What’s at stake: this year’s edition of the Jackson Hole symposium was awaited as an occasion to discuss how to redesign monetary policy for the future. We documented the state of academic and policymaking discussion on the topic in a previous review. But it seems the meeting has left many with the impression the Fed is not yet ready to start “rethinking normality”.

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