Policy Trilemma: Navigating the Limits of Monetary Autonomy
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…The policy trilemma, also known as the impossible or inconsistent trinity, says a country must choose between free capital mobility, exchange-rate management and monetary autonomy... Only two of the three are possible… Imagine a country that fixes its exchange rate against the US dollar and is also open to foreign capital. If its central bank sets interest rates above those set by the Federal Reserve, foreign capital in search of higher returns would flood in. These inflows would raise demand for the local currency; eventually the peg with the dollar would break. If interest rates are kept below those in America, capital would leave the country and the currency would fall.
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Where barriers to capital flow are undesirable, the trilemma boils down to a choice: between a floating exchange rate and control of monetary policy; or a fixed exchange rate and monetary bondage. Rich countries have typically chosen the former, but the countries that have adopted the euro have embraced the latter. The sacrifice of monetary-policy autonomy that the single currency entailed was plain even before its launch in 1999.
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In the run up, aspiring members pegged their currencies to the Deutschmark. Since capital moves freely within Europe, the trilemma obliged would-be members to follow the monetary policy of Germany... This monetary serfdom is tolerable for the Netherlands because its commerce is closely tied to Germany and business conditions rise and fall in tandem in both countries. For economies less closely aligned to Germany’s business cycle, such as Spain and Greece, the cost of losing monetary independence has been much higher: interest rates that were too low during the boom, and no option to devalue their way out of trouble once crisis hit.
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…The trilemma was an important outgrowth of the so-called Mundell-Fleming model, […] named in recognition of research papers published in the early 1960s by Robert Mundell and Marcus Fleming, showing that monetary policy becomes ineffective where there is full capital mobility and a fixed exchange rate…
…Hélène Rey, of the London Business School, has argued that a country that is open to capital flows, allowing its currency to float doesn’t necessarily enjoy full monetary autonomy. Her analysis starts with the observation that prices of risky assets tend to move in lockstep with the availability of bank credit and the weight of global capital flows, a reflection of a “global financial cycle” driven by shifts in investors’ appetite for risk. That in turn is heavily influenced by changes in the monetary policy of the Federal Reserve, which owes its power to the scale of borrowing in dollars by businesses and householders worldwide.
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When the Fed lowers its interest rate, borrowing in dollars becomes cheaper, driving up global asset prices, boosting the value of collateral against which loans can be secured. Global credit conditions are relaxed… Therefore, the Fed’s monetary policy shapes credit conditions in countries that have both flexible exchange rates and central banks that set their own monetary policy. Thus, the policy trilemma is really a dilemma… Ms Rey’s conclusion is more subtle: floating currencies do not adjust to capital flows in a way that leaves domestic monetary conditions unsullied, as the trilemma implies…
