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The Mundellian Trilemma and Optimal Monetary Policy in a World of High Capital Mobility

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Abstract

This paper proposes that the Mundellian Trilemma remains valid despite the emergence of a world financial cycle. A clear distinction must be made between monetary policy independence and insulation of an open economy’s financial system. A flexible exchange rate allows an optimizing central bank to chart an independent course but does not insulate the domestic financial sector or broader economy from foreign monetary or financial shocks. The gains from a flexible exchange rate may be considerable and vary in accordance with the mandate of the central bank. The Mundellian Trilemma highlights the acute shortage of policy instruments and resulting tradeoffs among policy goals.

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Notes

  1. Sceptics like Dunn (1983) questioned whether central banks ever embraced freely floating exchange rates. In his view, fear of the cost of highly variable real exchange rates induced central banks to manage exchange rates to a considerable extent. Later in the 1980s following the Plaza Accord in October 1985 and Louvre Accord in February 1987, the G-5 central banks engaged in co-ordinated foreign exchange market intervention to dampen fluctuations in the value of the U.S. dollar, further deviating from exchange rate flexibility.

  2. A clear statement about terminology is useful at the start. By monetary policy independence we mean that a central bank has unimpeded control of its instruments and proximate targets. Insulation of the financial sector is taken to mean that financial markets are shielded from world financial shocks and policy shocks originating in the United States and other major industrial countries. We avoid the terms: monetary independence or autonomy; “monetary” in this context is ambiguous. It is not clear whether these terms refer to central bank actions or to a broader context including banking and credit markets.

  3. Aizenman, Chinn and Ito (2020) estimate this correlation controlling for world economic conditions. They also examine how this measure of policy independence is affected by the implementation of macroprudential policies in the peripheral countries—an additional issue in the recent literature on the Trilemma.

  4. In the original non-stochastic Mundell-Fleming model exchange rate expectations are static so that Eq. (2) reduces to \({r}_{t}={r}_{t}^{f}\). Dornbusch (1976, 1980) introduces an arbitrage condition, essentially a form of the UIP equation, where a difference between the domestic and foreign interest rate is matched by a requisite expected exchange rate adjustment. See also Sohmen (1969, p. 114, fn. 29).

  5. From this point on, for simplicity of exposition, we will refer to \({r}^{f}\) as the U.S. policy rate.

  6. See also Dornbusch (1980; pp. 201–202). Both Mundell and Dornbusch reach this conclusion from analysis within a two-country version of the Mundell-Fleming framework. Sohmen (1969) objects to this characterization of “beggar-thy-neighbor” pointing out that in a system with flexible rates policymakers in the small country “are always perfectly free to adopt whatever expansionary policies they consider appropriate—in contrast with a system of fixed rates, in which their freedom of action may be seriously impaired” (p.214).

  7. This equivalence is consistent with the finding in Friedman (1975).

  8. An authoritative source on this point is Hicks (1946), “The rate of interest in Mr. Keynes General Theory is the long rate.”.

  9. An additional point made by Marston (1985: pp.907–912) is that to analyze foreign shocks, including foreign monetary policy shifts, it is necessary to take account of their context in the foreign economy with implications for the small open economy. Monetary policy shifts do not take place in a vacuum. Monetary policy shifts in major economies may destabilize emerging markets but lack of a policy response to financial shocks in those economies would also have destabilizing effects in emerging markets. In the context of recent U.S. monetary policy, this point is explored in Canzoneri et al. (2021).

  10. In addition to Marston (1985) examples of this literature are Aizenman and Frenkel (1985); Turnovsky (1983), (1987) and Benavie and Froyen (1991).

  11. Obstfeld (2020) notes that the word “insulation” does not appear in Johnson’s (1969) classic “Case for Flexible Exchange Rates.” Marston’s (1985) opinion was that “[f]lexible rates are widely thought to insulate an economy from foreign disturbances, probably because of the insulation achieved in models without capital mobility (p.907).” Capital flows are, however, central to current issues.

  12. In the cases we consider the expected inflation rate will be zero. The distinction between real and nominal interest rates will not be necessary. This follows from the fact that all shocks to the model will be assumed to be white noise. Introducing serially correlated disturbances makes the derivation of the algebraic results reported in this and the next section unnecessarily complex. Solving the model numerically under the assumption of autoregressive disturbances yields the same basic insights as the case of white noise disturbances. The foreign inflation rate will also be assumed to be zero, so there will be no distinction between real and nominal exchange rates.

  13. For the derivation of the open-economy New Keynesian IS equation, see Guender (2006).

  14. The treatment of optimal policy here assumes policy is conducted by discretion. Policy under commitment is an alternative framework [See Woodford (2003) or Froyen and Guender (2019)]. Distinctions between the two frameworks do not bear on the issues considered here.

  15. See, for example, the discussion in Monacelli (2013).

  16. The target rule is derived from constrained optimization. The central bank minimizes the loss function subject to the constraints of the model which, for b > 0, consist of both the Phillips Curve and the IS relation. The real exchanger rate is eliminated from the constraints through substitution of the UIP condition. The choice variables are the target variables – the rate of inflation and the output gap. For b = 0 the only constraint is the Phillips Curve.

  17. Not all versions of the New Keynesian model are based on the assumption of complete markets. Some derivations simply postulate the existence of riskless one-period bond. In general, given the assumption in these models of identical households, Woodford (2003: p.64) points out that “it makes no real difference what one assumes about the number of financial markets that are open.”.

  18. For example, Ravenna and Walsh (2006) consider a cost channel which introduces the interest rate into the Phillips Curve and thus indirectly an exchange rate channel.

  19. In an IMF Monograph, Chamon et al. (2019, p.vii) state that “In practice, inflation targeting central banks in emerging markets continued to closely monitor the exchange rate, not only for its implications for inflation, but because of financial stability risks that sharp exchange rate movements may entail.” This concern with exchange rate volatility, not only affects policy rates but also explains why foreign exchange market interventions have “always been an important component of central bank policy in emerging and developing economies Benes et al. (2015, p.82). Foreign exchange market intervention is considered in Sect. 5.

  20. The study by Eichengreen et al. (2020) is supportive this view,

  21. This was recognized early in the era of flexible exchange rates. See for example Peter Kenen (1985, pp.665–9).

  22. Losses in Tables 1 are calculated for Eq. 11. If Eq. 17 is used instead, the only difference results from the change in scaling of the weights (μ = 0.9524 compared to 1.0). The resulting value of loss function equals 2.49 compared to 2.62.

  23. In the model in Banerjee et al. (2016) the presence of a financial friction also increases the benefits of following an optimal policy that allows for exchange rate flexibility compared to a fixed exchange rate or inflexible inflation targeting.

  24. In economies with strong regulatory institutions, a solution to the instrument problem in an expanded framework is greater use of targeted macro-prudential instruments such as loan-to-value ratios and core funding ratios. The Reserve Bank of Australia in 2019 added an “articulation of the financial stability objective [Debelle (2018, p.55)],” to its existing dual mandate. The New Zealand Reserve Bank Act of 2021 “introduces the overarching objective of financial stability” [New Zealand Treasury (2021)], accompanied by a financial dashboard providing multiple metrics of the soundness of financial intermediaries.

  25. The title of the Farhi and Werning paper is “Dilemma Not Trilemma? Capital Controls, Exchange Rates and Volatile Capital Flows.”.

  26. Engel (2015) considers a role for capital controls to reduce market distortions such as those that lead to overborrowing. Engel (2015) and Cespedes et al. (2012) survey the experience of countries that maintained capital controls during and after the world financial crisis of 2007–2009. The Cespedes et al. study covers six Latin American countries that used selective reserve requirements, taxes and other restrictions to control various categories of capital flows. In the literature these measures are often represented by an interest equalization tax parameter. Landi and Schiavone (2021), in a detailed survey, find that capital controls are effective in restricting the size of the flows and the probability of surges and flights.

  27. In the current context sterilized intervention refers to foreign exchange market intervention accompanied by other central bank actions that leave the policy interest rate unchanged. Changes in that rate are a separate instrument. Intervention may or may not affect the monetary base.

  28. Both Blanchard (2017) and Liu and Spiegel (2015) consider application of an interest equalization tax on capital flows while Adrian et al. (2020) examine the imposition of a tax on capital outflows to limit severe depreciation of the domestic currency that widens a borrowing spread.

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Acknowledgements

The authors are grateful to Stanley W. Black for many helpful comments at various stages in our research for this paper. We are also grateful to an Associate Editor for perceptive comments that improved the paper in important ways.

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  1. Department of Economics CB3305, University of North Carolina, Chapel Hill, NC, 27599, USA

    Richard T. Froyen

  2. Department of Economics and Finance, University of Canterbury, Christchurch, New Zealand

    Alfred V. Guender

  3. Centre for Applied Macroeconomic Analysis, Canberra, Australia

    Alfred V. Guender

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Correspondence to Richard T. Froyen.

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Froyen, R.T., Guender, A.V. The Mundellian Trilemma and Optimal Monetary Policy in a World of High Capital Mobility. Open Econ Rev 33, 631–656 (2022). https://doi.org/10.1007/s11079-021-09662-2

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