Abstract:We develop a methodology that allows us to characterize in an intuitive manner the choices countries have made with respect to the trilemma during the post Bretton-Woods period. The first part of the paper deals with positive aspects of the trilemma, outlining new metrics for measuring the degree of exchange rate flexibility, monetary independence, and capital account openness. The evolution of our "trilemma indexes" illustrates that after the early 1990s, industrialized countries accelerated financial openness, but reduced the extent of monetary independence while sharply increasing exchange rate stability. This process culminated at the end of the 1990s with the introduction of the euro. In contrast, the group of developing countries pursued exchange rate stability as their key priority up to 1990, although many countries moved toward greater exchange rate flexibility from the early 1970s onward. Since 2000, measures of the three trilemma variables have converged towards intermediate levels characterizing managed flexibility, using sizable international reserves as a buffer, thus retaining some degree of monetary autonomy. Using these indexes, we also test the linearity of the three aspects of the trilemma: monetary independence, exchange rate stability, and financial openness. We confirm that the weighted sum of the three trilemma policy variables adds up to a constant, validating the notion that a rise in one trilemma variable should be traded-off with a drop of the weighted sum of the other two. The second part of the paper deals with normative aspects of the trilemma, relating the policy choices to macroeconomic outcomes such as the volatility of output growth and inflation, and medium term inflation rates. Some key findings for developing countries include: (i) greater exchange rate stability implies greater output volatility, which can only be slightly mitigated by reserve accumulation; (ii) somewhat counter to previous findings, greater exchange rate stability is also associated with greater inflation volatility, and (iii) greater monetary autonomy is associated with a higher level of inflation. We believe these results differ from those identified in previous studies due to the comprehensive nature of our analysis, which encompasses more than 100 countries and 37 years, as well as the inclusion of a number of additional structural and policy variables in the regressions. Nos.: F 15,F 21,F31,F36,F41,O24 JEL Classification

This paper tests the importance of precautionary and mercantilist motives in accounting for the hoarding of international reserves by developing countries, and provides a model that quantifies the welfare gains from optimal management of international reserves. While the variables associated with the mercantilist motive are statistically significant, their economic importance in accounting for reserve hoarding is close to zero and is dwarfed by other variables. Overall, the empirical results are in line with the precautionary demand. The effects of financial crises have been localized, increasing reserve hoarding in the aftermath of crises mostly in countries located in the affected region, but not in other regions. We also investigate the micro foundation of precautionary demand, extending Diamond and Dybvig (1983)'s model to an open, emerging market economy where banks finance long-term projects with short-term deposits. We identify circumstances that lead to large precautionary demand for international reserves, providing self-insurance against the adverse output effects of sudden stop and capital flight shocks. This would be the case if premature liquidation of long-term projects is costly, and the economy is de-facto integrated with the global financial system, hence sudden stops and capital flight may reduce deposits sharply. We show that the welfare gain from the optimal management of international reserves is of a first-order magnitude, reducing the welfare cost of liquidity shocks from a first-order to a second-order magnitude.

This paper tests the importance of precautionary and mercantilist motives in accounting for the hoarding of international reserves by developing countries, and provides a model that quantifies the welfare gains from optimal management of international reserves. While the variables associated with the mercantilist motive are statistically significant, their economic importance in accounting for reserve hoarding is close to zero and is dwarfed by other variables.Overall, the empirical results are in line with the precautionary demand. The effects of financial crises have been localized, increasing reserve hoarding in the aftermath of crises mostly in countries located in the affected region, but not in other regions. We also investigate the micro foundation of precautionary demand, extending Diamond and Dybvig (1983)'s model to an open, emerging market economy where banks finance long-term projects with short-term deposits. We identify circumstances that lead to large precautionary demand for international reserves, providing self-insurance against the adverse output effects of sudden stop and capital flight shocks. This would be the case if premature liquidation of long-term projects is costly, and the economy is de-facto integrated with the global financial system, hence sudden stops and capital flight may reduce deposits sharply. We show that the welfare gain from the optimal management of international reserves is of a first-order magnitude, reducing the welfare cost of liquidity shocks from a first-order to a second-order magnitude.

We estimate the pricing of sovereign risk for sixty countries based on fiscal space (debt/tax; deficits/tax) and other economic fundamentals over 2005-10. We measure how accurately the model predicts sovereign credit default swap (CDS) spreads, focusing in particular on the five countries in the South-West Eurozone Periphery (Greece, Ireland, Italy, Portugal, and Spain). Dynamic panel estimates of the model suggest that fiscal space and other macroeconomic factors are statistically significant and economically important determinants of market-based sovereign risk. Although the explanatory power of fiscal space measures drop during the crisis, the TED spread, trade openness, external debt and inflation play a larger role. As expectations of market volatility jumped during the crisis, the weakly concavity of creditors' payoff probably accounts for the emergence of TED spread as a key pricing factor. However, risk-pricing of the SouthWest Eurozone Periphery countries is not predicted accurately by the model either in-sample or out-of-sample: unpredicted high spreads are evident during global crisis period, especially in 2010 when the sovereign debt crisis swept over the periphery area. We "match" the periphery group with five middle income countries outside Europe that were closest in terms of fiscal space during the European fiscal crisis. We find that Eurozone periphery default risk is priced much higher than the "matched" countries in 2010, even allowing for differences in fundamentals. One interpretation is that the market has mispriced risk in the Eurozone periphery. An alternative interpretation is that the market is pricing not on current fundamentals but future fundamentals, expecting the periphery fiscal space to deteriorate markedly and posing a high risk of debt restructuring. Adjustment challenges of the Eurozone periphery may be perceived as economically and politically more difficult than the matched group of middle income countries because of exchange rate and monetary constraints.Keywords: CDS spreads, sovereign risk, fiscal space, default risk, Eurozone JEL: E43, F30, G01, H63 *We thank seminar participants at the Bank for International Settlements, Danmarks Nationalbank, the Bank of Canada, Columbia-Tsinghua international economics workshop, Chulalongkorn University (Sasin), and Association for Public Economic Theory 2011 Conference for very helpful comments. This paper investigates the pricing of risk associated with the sovereign debt crisis that escalated during 2010 in several European countries. Our objective is to determine whether the perception of relatively high sovereign default risk of the fiscally distressed Euro area countries, as seen in market pricing of credit default swap (CDS) spreads, may be explained by existing past or current fundamentals of debt and deficits relative to tax revenues -which we term de facto fiscal space -and other economic determinants. 2 Our analysis allows us to address several questions. Does fiscal space help systematically explain the evolution o...

This paper investigates how the trilemma policy mix affects economic performance in developing countries. We find that greater monetary independence can dampen output volatility, while greater exchange rate stability is associated with greater output volatility, which can be mitigated by reserve accumulation; greater monetary autonomy is associated with higher inflation, while greater exchange rate stability and greater financial openness is linked with lower inflation; pursuit of exchange rate stability can increase output volatility when financial development is at an intermediate stage. Greater financial openness, when accompanied by a high level of financial development, reduces output volatility. JEL Classification IntroductionAgainst the backdrop of the most severe financial crisis since the Great Depression, the issue of whether the trilemma -the hypothesis that a country can only achieve two, but not all three, goals of monetary independence, exchange rate stability and financial integration -seems rather distant. We argue that, on the contrary, determining the manner in which the trilemma has constrained policy choices is a question that needs to be answered in order to understand how the world economy has arrived at this juncture. East Asian reserve accumulation has been viewed as a contributing factor to the low interest rates blamed by some for the speculative excesses preceding the current financial crisis.A key message of the trilemma is instrument scarcity -policy makers face a tradeoff, where movement towards increasing the achievement of one trilemma policy goal, such as higher financial integration, induces a drop in the weighted average of the other two variables, i.e., lower exchange rate stability, lower monetary independence, or a combination of the two. 1In our previous paper (Aizenman, et al., 2008), we constructed indexes that measure the trilemma goals individually, for both industrialized and developing countries during the period 1970 to 2006. Using these indexes, we showed that the major crises -namely, the collapse of the Bretton Woods system, the debt crisis of 1982, and the Asian crisis of 1997-98 -caused structural breaks in the trilemma configuration. We also examined whether the three policy goals are "binding"; specifically, we tested the linearity of the indexes and confirmed that countries do face a trade-off among the three policy choices. This finding indicates that a change in any one of the trilemma variables induces a change with the opposite sign in the weighted average of the other two. With these results, we conclude that the present turbulence in global financial markets presents a serious challenge to the stability of the current trilemma configuration.A natural question follows: if policy makers are constrained to choose any two out of the three policy goals, what combination do they prefer? Hence, we test how each of the three policy choices as well as combinations of any two affect the economic outcomes policy makers focus on, such as output and infla...

We uncover a significant negative correlation between various volatility measures and private investment in developing countries, even when adding the standard control variables. No such correlation is uncovered when the investment measure is the sum of private and public investment spending. Indeed, public investment spending is positively correlated with some measures of volatility. These findings suggest that the detrimental impact of volatility on investment may be easier to detect using disaggregated data. We provide several possible interpretations for our findings. Nonlinearities in preferences or budget constraints can cause volatility to have first-order negative effects on private investment.

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We investigate why and how the financial conditions of developing and emerging market countries (peripheral countries) can be affected by the movements in the center economies -the U.S., Japan, the Eurozone, and China. We apply a two-step approach. First, we estimate the sensitivity of countries' financial variables to the center economies [policy interest rate, stock market prices, and the real effective exchange rates (REER)] while controlling for global and domestic factors. Next, we examine the association of the estimated sensitivity coefficients with the macroeconomic conditions, policies, real and financial linkages with the center economies, and the level of institutional development. In the last two decades, for most financial variables, the strength of the links with the center economies have been the dominant factor while the movements of policy interest rate also appear sensitive to global financial shocks around the emerging market crises of the late 1990s and since the global financial crisis of 2008. While certain macroeconomic and institutional variables are important, the arrangement of open macro policies such as the exchange rate regime and financial openness are also found to have direct influence on the sensitivity to the center economies. An economy that pursues greater exchange rate stability and financial openness faces a stronger link with the center economies through policy interest rates and real effective exchange rate (REER) movements. We also find exchange market pressure (EMP) in peripheral economies is sensitive to the movements of the center economies' REER and EMP during and after the global financial crisis. Open macro policy arrangements, especially exchange rate regimes, also have indirect effects on the strength of financial linkages, interacting with other macroeconomic conditions. Thus, trilemma policy arrangements, including exchange rate flexibility, continue to affect the sensitivity of developing countries to policy changes and shocks in the center economies.