Monetary Trilemma

6 Key excerpts on "Monetary Trilemma"

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  eBook - ePub

  The Evidence and Impact of Financial Globalization

  • (Author)
  • 2012(Publication Date)
  • Academic Press

    (Publisher)

  An alternative way for the small open economy to regain its monetary independence is to give up financial integration and opt for exchange-rate stability and monetary independence. Giving up financial integration prevents arbitrage between domestic and foreign bonds, thereby delinking the domestic interest rate from the foreign interest rate. Monetary policy operates in ways similar to the closed economy, where, in the short run, the central bank controls the supply of money and monetary expansion reduces the domestic interest rate. This policy configuration corresponds to the policy pair associated with the left and the right side of the trilemma triangle, attainable under closed financial markets and a pegged exchange rate, that is, the top vertex. Monetary independence in this case gets traded off with financial integration.

  The sharp predictions of the trilemma and its crisp intuitive interpretation made it the Holy Grail of the open-economy neo-Keynesian paradigm. The impossible trinity has become self-evident for most academic economists. Today, this insight is also shared by practitioners and policy makers alike. A lingering challenge is that, in practice, most countries rarely face the binary choices articulated by the trilemma. Instead, countries chose the degree of financial integration and exchange-rate flexibility. Even in rare cases of adoption of a strong version of a fixed exchange-rate system (like the currency-board regime chosen by Argentina in the early 1990s), the credibility of the fixed exchange rate changes overtime, and the central bank rarely follows the strict version of currency board. Similarly, countries choosing a flexible exchange-rate regime, occasionally (some frequently) actively intervene in foreign currency markets, and end up implementing different versions of a managed float system. Furthermore, most countries operate in the gray range of partial financial integration, where regulations restrict flows of funds. Understanding these mixed regimes remains a challenge.

  Testing the predictions of the trilemma paradigm remains work in progress, as there is no unique way to define and measure the degree of exchange-rate flexibility, monetary autonomy, and financial integration. Proper modeling of limited financial integration and limited substitutability of assets remains debatable. Yet, even in this murky situation, the trilemma remains a potent paradigm. A key message of the trilemma is scarcity of policy instruments. Policy makers face a trade-off, where increasing one trilemma variable (such as higher financial integration) would induce a drop in the weighted average of the other two variables (lower exchange-rate stability, or lower monetary independence, or a combination of the two). We continue with a review of the changing trilemma configurations of countries during recent decades, then discuss the empirical literature dealing with the evolving trilemma configurations, and finally interpret challenges facing countries that have been navigating the trilemma throughout the globalization process.

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  eBook - ePub

  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  In the previous two chapters, we covered two separate types of exchange rate systems. Most of the world’s countries have opted for some form of floating exchange rate. This sort of system has the advantage of making it easier to manage the domestic economy or internal balance. In the following chapter, we covered the macroeconomics of a fixed exchange rate system. In that chapter, we showed that having fixed exchange rates makes monetary policy less effective. As one may have noticed, the existence of a fixed exchange rate as a policy goal may make internal balance more difficult to manage. In our discussion of the choice of an exchange rate system, this is a point that has been lingering in the background but not explicitly brought out. In part, the omission is present because, to economists, it has become deeply embedded in our thinking—so much so that we typically say nothing about it. However, if one is not an economist, talking about the “incompatible trinity” (sometimes referred to as the “trilemma”) has some value. In the 1950s, Robert Mundell pointed out that three policies were fundamentally incompatible. These policies are perfect capital mobility, fixed exchange rates, and an effective monetary policy. A country can accomplish two out of the three, but not all three together. In the previous two chapters, we have already shown this, to an extent. If the exchange rate is floating, monetary policy will be effective. If the exchange rate is fixed, monetary policy becomes less effective. However, in both chapters we assumed the existence of perfect capital mobility.

  A floating exchange rate implies a conscious decision concerning the trilemma. Countries using this system have chosen to let the exchange rate float and to allow capital mobility. This is not the only solution to the problem. As we will see in the next chapter, there have been other choices made at other times. In the past, countries chose to fix the exchange rate, allow capital mobility, and not be as concerned with monetary policy. Another type of international monetary system was designed for the policy choice of fixed exchange rates with a focus on internal balance. As we will see, this system eventually failed because it also allowed capital mobility. Since capital mobility was allowed, there was no explicit solution to the trilemma. In any case, as we move through the modern history of international monetary systems, the trilemma is a useful concept to keep in mind. The same will apply to much of our discussion in Chapter 20 . The trilemma may be an uncomfortable reality, but any exchange rate system that does not take this tradeoff into account may not be viable in the long run.

  THE EUROPEAN MONETARY UNION

  For more than twenty years, the European Union has been attempting to achieve the degree of exchange rate stability within Europe that the old Bretton Woods system had. As trade barriers fell in Europe and trade increased, the instability of exchange rates became increasingly important as a deterrent to both trade and investment. This led the EU to seek some form of an exchange rate regime that would promote more exchange rate stability. Over the past several years a new word—the euro—has entered the jargon of international economics and business. The origins of the euro can be traced back to the mid-1970s. With the breakdown of the Bretton Woods system, a number of members of the EU joined a system informally called “the snake.” Essentially, this system was one in which a number of countries pegged their nominal exchange rates to the German mark. In 1979, this rather informal arrangement turned into the more formal European Monetary System (EMS). Countries could keep their nominal exchange rates fixed only by keeping their inflation rates and real interest rates close to those of Germany. This effectively meant that the German central bank (the Bundesbank) was setting monetary policy for all countries in the EMS. Discomfort among some EU members over this “German dominance of the EMS” was what led to negotiations for a single currency.

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  Ruling Capital

  Emerging Markets and the Reregulation of Cross-Border Finance

  • Kevin P. Gallagher(Author)
  • 2015(Publication Date)
  • Cornell University Press

    (Publisher)

  These works attempted to uncover the optimal policy mix as well as the optimal exchange rate regime for open economies with mobile capital. One main conclusion of Mundell (1963) is that perfect capital mobility, a fixed exchange rate regime, and independent monetary policy cannot all coexist; countries can maintain at most two of the three. Moreover, the Mundell-Fleming model explicitly verifies that if capital is internationally mobile and the nominal exchange rate is fixed, monetary policy is constrained to only altering the level of international reserves, while fiscal policy can effectively alter output. Fleming (1962) specifically offers these conclusions in his analysis of government policies. The trilemma result of Mundell-Fleming provides a basis for which policy responses to external shocks (e.g., capital inflows and outflows), especially in emerging markets, can be analyzed. Economists such as James Tobin (1978, 1998) sees this trilemma as the rationale for an activist monetary policy in pursuit of full employment. Numerous studies show that capital controls were effective outside the United States during this period as well. Work by Maurice Obstfeld (1993), Richard Marston (1993), and Kouri and Porter (1974) demonstrated how controls were effective in the 1960s in the United Kingdom, Germany, Australia, Italy, and the Netherlands.

  Despite the fact that new classical economics came to dominate macroeconomic thinking, work in the Mundell-Fleming tradition still held traction in the profession. Some economists adopted new Keynesian models that borrowed from the new classical models and attempted to use microfoundations to articulate the impossible trilemma, but under sticky wages and prices. Obstfeld and Kenneth Rogoff (1995) continue to follow the tradition of formalizing the trilemma in such a context. A group of economists have formally modeled some of the ideas that could be seen as more in the (new) Keynesian tradition, operating in a dynamic general equilibrium context with sticky prices and sometimes sticky wages. In addition, a group of empirically based economists have examined the extent to which nations still face a trilemma in the contemporary world. There is an emerging consensus in this new literature that the impossible trinity remains a very real challenge in the twenty-first century and that, in certain circumstances, restricting capital mobility is the optimal route to macroeconomic stability.

  There has been a resurgence in this line of thought since the new classical perspective rapidly lost traction in the wake of the global financial crisis. In that tradition, Emmanuel Fahri and Ivan Werning (2013) use a general equilibrium framework with microfoundations and sticky wages and prices that builds on microfounded models of Obstfeld and Rogoff (1995). They find that capital controls are the optimal way to respond to external shocks. Perhaps most interesting is that, in the presence of sticky wages and prices, they find that capital controls may be optimal even with a floating exchange rate.

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  Analytical Gains of Geopolitical Economy

  • Radhika Desai, Paul Zarembka(Authors)
  • 2016(Publication Date)
  • Emerald Group Publishing Limited

    (Publisher)

  PART I THE INTERNATIONAL MONETARY SYSTEM This page intentionally left blank THE INHERENT INSTABILITY OF NATIONAL MONETARY POWER IN THE 21ST CENTURY: THE TRIFFIN DILEMMA REVISITED Juan Barredo-Zuriarrain ABSTRACT Recent research in mainstream economics, before as well as since the 2008 crisis, has stressed the importance of growing current account imbalances among countries, particularly the imbalances between the United States and some Asian countries. While some have seen in these imbalances proof of the efficient work done by liberalized financial mar-kets, as well as a sign of the great dynamism of the US economy, others have warned about the possible threats to the global economic stability arising from potential speculation against the dollar. These latter writers see the international imbalances as a contemporary version of the Triffin Dilemma. In this paper, we argue that both views are mistaken because they both focus on net capital flows. Recent research suggests, on the contrary, the importance of international gross capital flows related to financial liberalization. However, our argument goes further in order to demonstrate that the analysis of the consequences of international gross Analytical Gains of Geopolitical Economy Research in Political Economy, Volume 30B, 25 52 Copyright r 2016 by Emerald Group Publishing Limited All rights of reproduction in any form reserved ISSN: 0161-7230/doi: 10.1108/S0161-72302015000030B002 25 capital flows were already at the core of the Triffin dilemma, as well as in wider debates about the inherent instability of the international mone-tary power of individual countries, before and after World War II. Keywords: Global imbalances; financial liberalization; gross capital flows; Triffin dilemma JEL classifications: E42; F32 INTRODUCTION One of the most important debates of the years before the crisis stressed the rise of global imbalances between the largest current account surpluses and deficits.

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  Available until 4 Dec |Learn more

  Global Political Economy

  Theory and Practice

  • Theodore H. Cohn, Anil Hira(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  55 The three elements of the Unholy Trinity are exchange-rate stability, private capital mobility, and monetary policy autonomy. Economists assert that states can attain only two of these three goals simultaneously. With flexible exchange rates, states can gain monetary autonomy as they do not need to intervene in currency markets; but they will lose exchange rate stability. With pegged exchange rates and capital mobility, a state’s attempt to follow independent monetary policies can lead to capital flight and a downward pressure on the currency exchange rate until the state alters its monetary policies. For example, if domestic interest rates differ from global interest rates, capital flows can quickly eliminate the difference, and the state loses monetary policy autonomy. Since most states have accepted a high degree of capital mobility and cannot reverse this trend, the Unholy Trinity involves a trade-off between pegged exchange rates and policy autonomy. In shifting to floating exchange rates, states opted for more policy autonomy.

  Although the shift to floating rates has permitted larger DCs to follow more independent monetary policies, most economists underestimated the degree to which increased capital mobility would disrupt exchange rates. As orthodox liberalism returned, the United States and Britain rejected any further attempts to control capital flows, and other DCs soon followed because countries were competing for foreign investment. The integration of financial markets, combined with technological advances, contributed to a massive growth in speculative capital flows. Thus, volatility and misalignment of currencies have been serious problems with the floating exchange rate regime. Volatility refers to the short-term instability of exchange rates. Under the floating system, unpredictable capital flows can produce highly volatile exchange rates that create uncertainty, inhibit productive investments, and interfere with international trade. Misalignment refers to the long-term departure of exchange rates from competitive levels. If a currency does not reflect the demand and supply for it in global markets, the state will have to use its reserves and/or intervene in currency market purchases (such as limiting the number of dollars that can be locally purchased, or setting up different exchange rates for different purchasers). Misalignment is even more serious than volatility because it leads to prolonged changes in international competitiveness. Depending on whether a currency is under- or overvalued, misalignment gives a country substantial price advantages or disadvantages vis-à-vis its competitors.56

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  American Divergences in the Great Recession

  • Daniele Pompejano(Author)
  • 2021(Publication Date)
  • Routledge

    (Publisher)

  Introduction The Dilemma of Currency

  Known as the “Triffin dilemma”, the concept emerged well before the release of the dollar from gold on August 15, 1971. Given the insufficiency of the precious metal, the currency of the country with the strongest economy – the pound, and, more recently, the dollar – is historically assumed as a unit of account but also as an essential complement to reserves. It, therefore, responds to the domestic needs of the issuing country, but also provides the actors in international trade with means of payment. The paradox is that the seigniorage in the issue corresponds to a non-financial current account deficit, which, in the long run, may undermine the confidence placed in the currency used as a reserve. But it is no less important that the country that issues the currency of reference ends up importing capital from countries whose economies require resources (Triffin, 1961 ).

  We can link this contradiction to several more fundamental ambiguities. The oldest and most primal speaks of the nature itself of the currency; that is, metal commodity money and then the so-called fiduciary money, banknotes printed by commercial banks or by the central bank. For just under a century, the latter has been entrusted with the task of dispensing credit as a last resort and intervening in support of financial institutions in temporary difficulty. But this function, which seems completely natural today, has been the result of a complex process involving the intertwining of the dynamics of private and public, internal and international interests (Fergusson, 2009 ). From the reduced boundaries of national sovereignty, the function of a currency as the fulcrum of compensation systems has expanded internationally and far beyond its function as a mediator of trade. In the First World War, the issuance of money and the production of credit instruments were essential in sustaining the mobilisation of the war and the subsequent reconstruction in a regime of so-called suspended money supply (Maier, 1984 ).1

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