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 Topic: Global economy and trade

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.

Read article More by this author
 

Blog Post

It’s hard to live in the city: Berlin’s rent freeze and the economics of rent control

A proposal in Berlin to ban increases in rent for the next five years sparked intense debate in Germany. Similar policies to the Mietendeckel are currently being discussed in London and NYC. All three proposals reflect and raise similar concerns – the increase in per-capita incomes is not keeping pace with increases in rents, but will a cap do more harm than good? We review recent views on the matter.

By: Inês Goncalves Raposo Topic: Macroeconomic policy Date: July 8, 2019
Read article More on this topic
 

Blog Post

The breakdown of the covered interest rate parity condition

A textbook condition of international finance breaks down. Economic research identifies the interplay between divergent monetary policies and new financial regulation as the source of the puzzle, and generates concerns about unintended consequences for financing conditions and financial stability.

By: Konstantinos Efstathiou and Bruegel Topic: Banking and capital markets Date: July 1, 2019
Read article More on this topic
 

Blog Post

The June Eurogroup meeting: Reflections on BICC

The Eurogroup met on June 13th to discuss the deepening of the economic and monetary union (EMU) and prepare the discussions for the Euro Summit. From the meeting came two main deliverables: an agreement over a budgetary instrument for competitiveness and convergence and the reform of the European Stability Mechanism (ESM) treaty texts. We review economists’ first impressions.

By: Bruegel and Inês Goncalves Raposo Topic: Macroeconomic policy Date: June 24, 2019
Read article More on this topic
 

Blog Post

The campaign against ‘nonsense’ output gaps

A campaign against “nonsense” consensus output gaps has been launched on social media. It has triggered responses focusing on the implications of output gaps for fiscal policy under EU rules, especially for Italy. But the debate about the reliability of output-gap estimates is more wide-ranging.

By: Konstantinos Efstathiou and Bruegel Topic: Macroeconomic policy Date: June 17, 2019
Read article More on this topic
 

Blog Post

The inverted yield curve

Longer-term yields falling below shorter-term yields have historically preceded recessions. Last week, the US 10-year yield was 21 basis points below the 3-month yield, a feat last seen during the summer of 2007. Is the current yield curve a trustworthy barometer for future growth?

By: Inês Goncalves Raposo and Bruegel Topic: Global economy and trade Date: June 11, 2019
Read article More on this topic
 

Blog Post

The 'seven' ceiling: China's yuan in trade talks

Investors and the public have been looking at the renminbi with caution after the Trump administration threatened to increase duties on countries that intervene in the markets to devalue/undervalue their currency relative to the dollar. The fear is that China could weaponise its currency following the further increase in tariffs imposed by the United States in early May. What is the likelihood of this happening and what would be the consequences for the existing tensions with the United States, as well as for the global economy?

By: Inês Goncalves Raposo and Bruegel Topic: Global economy and trade Date: June 3, 2019
Read article More on this topic
 

Blog Post

The next ECB president

On May 28th, EU heads of state and government will start the nomination process for the next ECB president. Leaving names of possible candidates aside, this review tries to isolate the arguments about what qualifications the new president should have and what challenges he or she is likely to face.

By: Bruegel and Konstantinos Efstathiou Topic: Macroeconomic policy Date: May 27, 2019
Read article More on this topic More by this author
 

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2019 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: Macroeconomic policy Date: May 20, 2019
Read article More by this author
 

Blog Post

Is an electric car a cleaner car?

An article published by the Ifo Institute in Germany compares the carbon footprint of a battery-electric car to that of a diesel car, and argues a higher share of electric cars will not contribute to reducing German carbon dioxide emissions. Respondents rejected the authors’ calculations as unrealistic and biased, and pointed to a series of studies that conclude the opposite. We summarise the article and responses to it.

By: Michael Baltensperger Topic: Digital economy and innovation, Green economy Date: May 13, 2019
Read article More on this topic More by this author
 

Blog Post

All eyes on the Fed

Last week the US Federal Reserve left the federal funds rate unchanged and lowered the interest rate on excess reserves. We review economists’ recent views on the monetary policy conduct and priorities of the United States’ central bank system.

By: Inês Goncalves Raposo Topic: Global economy and trade Date: May 6, 2019
Read article More on this topic More by this author
 

Blog Post

Is this blog post legal (under new EU copyright law)?

How new EU rules on using snippets from news publishers and on copyright infringement liability might affect circulation of information, revenue distribution, market power and EU business competitiveness.

By: Catarina Midões Topic: Macroeconomic policy Date: April 8, 2019
Read article More on this topic
 

Blog Post

Secular stagnation and the future of economic stabilisation

Larry Summers’ and Łukasz Rachel’s most recent study documents a secular fall in neutral real rates in advanced economies. According to the authors, this fall would be even more marked in the absence of offsetting fiscal policies. Policymaking in a world of permanently low interest rates may be hard to navigate, especially in troubled waters. We review economists’ views on the matter

By: Inês Goncalves Raposo and Bruegel Topic: Macroeconomic policy Date: April 1, 2019
Load more posts