Determinants of the Trilemma Policy Combination

37 Pages Posted: 1 Feb 2014

See all articles by Hiro Ito

Hiro Ito

Portland State University - Department of Economics

Masahiro Kawai

Asian Development Bank Institute

Date Written: January 30, 2014

Abstract

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

Ito, Hiro and Kawai, Masahiro, Determinants of the Trilemma Policy Combination (January 30, 2014). ADBI Working Paper No. 456. Available at SSRN: https://ssrn.com/abstract=2388505 or http://dx.doi.org/10.2139/ssrn.2388505

Hiro Ito (Contact Author)

Portland State University - Department of Economics ( email )

Portland, OR 97207-0751
United States
503-725-3930 (Phone)
503-725-3945 (Fax)

HOME PAGE: www.econ.pdx.edu

Masahiro Kawai

Asian Development Bank Institute ( email )

Kasumigaseki Building 8F 3-2-5
Kasumigaseki Chiyoda-ku
Tokyo, 100-6008
Japan

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