New Measures of the Trilemma Hypothesis: Implications for Asia

Abstract

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Trilemma Challenges for the People's Republic of China

“…The trilemma is often illustrated using a triangle as shown in Figure 1, with the three sides representing the three desirable properties: exchange rate stability, financial market openness, and monetary policy autonomy (Ito and Kawai 2014). While it is possible to achieve desired levels of two out of the three attributes, it is impossible to achieve desired levels of all three.…”

“…As only two out of three can be achieved to their full extent (or any extent), we often observe three distinctive policy combinations: (i) a fixed exchange rate regime and full monetary policy autonomy (with closed financial markets, as in the case of the lower left-hand corner-representing, for example, the Bretton Woods system and the PRC in the pre-1990s); (ii) a fixed exchange rate regime and fully open financial markets (while giving up monetary policy autonomy, as in the case of the lower right-hand corner-representing, for example, the gold standard system, a currency board system similar to Hong Kong, China and small eurozone countries); and (iii) fully open financial markets and full monetary policy autonomy (while adopting a freely flexible exchange rate regime as in the case of the top corner-representing for example, Australia, Canada, Japan, and the United Kingdom). Source: Ito and Kawai (2014).…”

“…First, following Ito and Kawai (2014), we propose using the following equations to test the PRC's monetary policy autonomy: 12 In the Taylor rule of equation (5), t ỹ is the growth rate of industrial production and t π is the inflation gap, i.e., the difference between the actual and target inflation rates. 13 Equation (6) is a combination of equations (4) and (5).…”

“…13 Equation (6) is a combination of equations (4) and (5). Ito and Kawai (2014) then use the overall estimation performance of equations (4), (5), and (6) to judge the degree of monetary policy autonomy. If the PRC's monetary policy closely follows the monetary policy of the base country, the coefficient 0 β is significantly positive and close to unity and the goodness of fit of equation (4) is high.…”

The Renminbi and Exchange Rate Regimes in East Asia

“…Table 3 summarizes the state of capital account liberalization as reported by the PBC. Sources: Chinn and Ito (2008) and website; Ito and Kawai (2012).…”