Determinants of the Trilemma Policy Combination
37 Pages Posted: 1 Feb 2014
Date Written: January 30, 2014
This paper presents a theoretical framework for policy making based on the “impossible trinity” or the “trilemma” hypothesis. A simple optimization model shows that placing more weight in terms of preference for each of the three open macroeconomic policies — exchange rate stability, financial market openness, and monetary policy independence — contributes to a higher level of achievement in that particular policy. The paper goes on to develop the first empirical framework in the literature to investigate the joint determination of the triad open macroeconomic policies based on the trilemma hypothesis. Results from applying the seemingly unrelated regression estimation method and employing other robustness checks show that simple economic and structural fundamentals determine the trilemma policy combinations. Finally, the paper examines how deviations from the “optimal” trilemma policy combinations evolve around the time of a financial crisis.
Keywords: trilemma hypothesis, macroeconomic policy, exchange rate stability, financial market openness, monetary policy independence, financial crisis, policy combination
JEL Classification: F15, F21, F31, F36, F41, O24
Suggested Citation: Suggested Citation