Impossible trinity in a small open economy: A state-space model informed policy simulation

30 Pages Posted: 12 Jul 2021

See all articles by Guna Raj Bhatta

Guna Raj Bhatta

School of Business, Faculty of Business and Law, University of Wollongong

Rabindra Nepal

School of Accounting, Economics, and Finance, University of Wollongong

Kankesu Jayanthakumaran

University of Wollongong - Department of Economics

Charles Harvie

University of Wollongong

Date Written: July 8, 2021

Abstract

Should monetary policy independence be maintained when the exchange rate is fixed under closed capital account conditions in a small open economy? We apply the Kalman filter at State Space model to test the Nepalese economy’s policy trilemma condition involving restricting capital flow, maintaining policy independence and fixing the exchange rate over the period 1989-2019. Accounting for two-thirds of Nepal’s total trade, Nepal is heavily trade-dependent to India in South Asia, which underwent economic liberalisation during the early 1990s. We modify the traditional Taylor-rule-based monetary policy reaction function to more closely represent Nepal’s economic characteristics by mixing backward-looking and forward-looking strategies and incorporating a fixed exchange rate in the monetary policy reaction function. The simulation results provide strong evidence of policy trilemma failure and inevitable policy trade-offs. In the monetary policy reaction function of both domestic and foreign conditions, the parameter value of domestic condition needs to be close to zero, to get the simulated interest rate close to observed. The loss of monetary policy independence raises a range of policy issues for the Nepalese economy: the rationale for fixing the exchange rate, and the efficacy of capital account closure which might deteriorate the effectiveness of monetary policy.

Keywords: Monetary Policy Independence, Impossible Trinity, State Space Model, Calibration, Policy Simulation

JEL Classification: E47, E52, E58

Suggested Citation

Bhatta, Guna Raj and Nepal, Rabindra and Jayanthakumaran, Kankesu and Harvie, Charles, Impossible trinity in a small open economy: A state-space model informed policy simulation (July 8, 2021). CAMA Working Paper No. 60/2021, Available at SSRN: https://ssrn.com/abstract=3882308 or http://dx.doi.org/10.2139/ssrn.3882308

Guna Raj Bhatta

School of Business, Faculty of Business and Law, University of Wollongong ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

Rabindra Nepal (Contact Author)

School of Accounting, Economics, and Finance, University of Wollongong ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

Kankesu Jayanthakumaran

University of Wollongong - Department of Economics ( email )

Northfields Avenue
Wollongong, New South Wales 2522
Australia

Charles Harvie

University of Wollongong ( email )

Wollongong, NSW 2522
Australia

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
72
Abstract Views
295
rank
448,281
PlumX Metrics