Assessing the Emerging Global Financial Architecture: Measuring the Trilemma's Configurations over Time

Abstract

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

New Measures of the Trilemma Hypothesis: Implications for Asia

“…In our exploration, we take a different and more nuanced approach than the previous indexes developed by Aizenman, Chinn, and Ito (2008). We show that the new indexes add up to the value two, supporting the trilemma hypothesis.…”

“…If one does not know to what extent each of the policy choices has been achieved, it is difficult to understand the extent of other policy choices available. Aizenman, Chinn, and Ito (2008) developed a set of "trilemma indexes" that measure the degree of achievement of the three policy choices for a wide coverage of countries and periods. Using the indexes, they empirically supported the hypothesis by showing that the three measures of the trilemma are linearly related to each other.…”

Is India Ready for Inflation Targeting?

“…A fundamental contribution of the Mundell-Fleming framework is the impossible trinity, which states that a country may choose any two, but not all of the following three goals at the same time: monetary independence, exchange rate stability and capital account openness or financial integration (Aizenman, et al, 2008). Under this standard framework of the impossible trinity, given India's enhanced integration with global capital markets, there would be a tension between monetary independence and exchange rate management.…”

Does the nominal exchange rate regime affect the real interest parity condition?

“…countries may reach at most two out of three goals: monetary independence, exchange rate stability and financial integration, see Aizenman, Chinn and Ito (2008) 3 . Under the Gold Standard highly integrated product and financial markets have caused a fast adjustment towards parity.…”