Policy Trilemma

4 Key excerpts on "Policy Trilemma"

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  eBook - PDF

  Central Banks at a Crossroads

  What Can We Learn from History?

  • Michael D. Bordo, Øyvind Eitrheim, Marc Flandreau, Jan F. Qvigstad(Authors)
  • 2016(Publication Date)
  • Cambridge University Press

    (Publisher)

  Clearly, it is not possible to be simultaneously on all three sides of the triangle. For instance, the top point, labeled “closed capital markets” is associated with monetary policy autonomy and a fixed exchange rate regime and the absence of financial integration. 5 Figure 10.1: The trilemma of international finance 5 See Obstfeld, Shambaugh, and Taylor (2005) for further discussion and references dealing with the trilemma. 390 Menzie D. Chinn Countries have adopted different arrangements aimed at achieving combinations of two out of the three policy goals. The Gold Standard delivered capital mobility and exchange rate stability; the Bretton Woods system provided monetary autonomy and exchange rate stability. The fact that different economies have opted for different combinations indi- cates that policy authorities trade off certain goals as economic conditions evolve. 6 Greater monetary independence allows policy makers to stabilize the economy through monetary policy without being subject to other econ- omies’ macroeconomic outcomes, thus potentially insulating the economy. However, in a world with price and wage rigidities, the resulting room for discretion means that policy makers might manipulate output movement, thus leading to increasing output and inflation volatility. On the other hand, monetary independence could permit a monetary authority to pursue an alternative nominal anchor that might simultaneously overcome the time inconsistency problem and preserve the option of pursuing countercyclical monetary policy. 7 Alternatively, price stability could potentially be achieved through exchange rate stability; such stability could also mitigate interest rate and exchange rate uncertainty, thereby lowering the risk premium. The trade- off is that greater levels of exchange rate stability could deprive policy makers of the option of using the exchange rate as a shock absorber.

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  The Evidence and Impact of Financial Globalization

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

    (Publisher)

  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.

  The Trilemma Choices of Countries – Trends and Trade-offs

  Figure 27.2 summarizes the changing patterns of trilemma during the 1970–2006 period. It reports the trilemma indices for 50 countries (32 of which are developing countries) during the 1970–2006 period, for which there is a balanced dataset. Figure 27.2(a) vividly shows that, after the breakup of the Bretton Woods system, industrial countries significantly reduced the extent of exchange-rate stability until the early 1980s. Overall, for the industrial countries, financial openness accelerated after the beginning of the 1990s and exchange-rate stability rose after the end of the 1990s, reflecting the introduction of the euro in 1999. In line with the trilemma predictions, monetary independence experienced a declining trend, especially since the early 1990s.

  Figure 27.2 The evolution of trilemma indices: (a) industrial countries; (b) emerging market countries; (c) nonemerging market developing countries. Definitions: The index for the extent of monetary independence (MI); MI = 1 − 0.5[corr(i i , i j ) − (−1)], where i refers to home countries and j to the base country. By construction, higher values of the index mean higher monetary policy independence. Exchange-rate stability (ERS), ERS = Annual standard deviations of monthly exchange-rate series between the home country and the base country calculated and included in the following formula to normalize the index between 0 and 1: ERS = 0.01/[0.01 + st dev(Δ(log(exch_rate))]. Financial openness (KAOPEN): KAOPEN = A de jure

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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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  Freedom, Efficiency and Equality

  • T. Wilkinson(Author)
  • 2000(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  At this stage, we have the problem that if people are free to choose their lines of work and they are to be paid equally, then the ab- sence of incentives will ensure inefficiency. We can think of the problem as a trilemma where one cannot have all three values simultaneously. According to the trilemma, one could have equality and freedom, as we saw, but only at the price of inefficiency. Alter- natively, one could have freedom and efficiency-promoting incentives, but then there would be inequality. Or one could conscript labour to replace the need for incentives, in which case one might get equality and efficiency, but one would have rejected freedom. 2 If there really is a trilemma where one could not have equality without rejecting either freedom or efficiency, that would be a big problem for egalitarians. If freedom and efficiency are taken in the more attractive of the senses described in earlier chapters, it seems hard to argue that equality could be more important than them. If there really was a trilemma, it should be equality that goes. Be that as it may, I hope to show, in the course of this book, that there is no trilemma, and we do not have to choose between equality, freedom and efficiency. The Trilemma 71 We can distinguish two different ways in which an egalitarian might respond to the trilemma. It might be claimed that freedom, efficiency and equality are not values that can conflict, in which case it follows, of course, that there cannot be a trilemma. Or it might be claimed that, even if they can conflict, they need not because there are possible social systems which achieve all three values. The view that freedom, efficiency, and equality cannot conflict relies on a philosophical analysis of the values concerned. So too, for the most part, do some attempts to argue that the values do not conflict.

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