Discussion Paper Series 2013-E-14

Rounding the Corners of the Policy Trilemma:
Sources of Monetary Policy Autonomy

Michael W. Klein, Jay C. Shambaugh

A central result in international macroeconomics is that a government cannot simultaneously opt for open financial markets, fixed exchange rates, and monetary autonomy; rather, it is constrained to choosing no more than two of these three. In the wake of the Great Recession, however, there has been an effort to address macroeconomic challenges through intermediate measures, such as narrowly targeted capital controls or limited exchange rate flexibility. This paper addresses the question of whether these intermediate policies, which round the corners of the triangle representing the policy trilemma, afford a full measure of monetary policy autonomy. Our results confirm that extensive capital controls or floating exchange rates enable a country to have monetary autonomy, as suggested by the trilemma. Partial capital controls, however, do not generally enable a country to have greater monetary control than is the case with open capital accounts unless they are quite extensive. In contrast, a moderate amount of exchange rate flexibility does allow for some degree of monetary autonomy, especially in emerging and developing economies.

Keywords: Exchange Rate Regimes; Trilemma; Monetary Policy; Capital Controls

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

Copyright © 2013 Bank of Japan All Rights Reserved.

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