On Some Ways to Mitigate the Macroeconomic Policy Trilemma

Abstract

The choice of a macroeconomic policy in an open economy is constrained by a trilemma in which only two of the following three policy goals can be achieved at the same time: exchange rate stability, monetary independence, and capital mobility. The constraints on economic policy imposed by this trilemma have been confirmed in both theory and practice for more than sixty years. Central banks are nevertheless forced to seek some compromise that will relax those constraints. The economic literature has proposed various tools and mechanisms for making them less rigid and facilitating central banks in reaching their policy goals, an especially urgent concern for developing countries. The tools that have been offered were effective before the global financial crisis, but this study shows that they have now lost their usefulness because global economic trends linked to capital flows, exchange rate stability, and debt dynamics have changed. The paper assesses the effectiveness of the best-known instruments for easing the trilemma, such as accumulating large foreign exchange reserves and foreign exchange interventions by monetary authorities that partially substitute for capital controls. A new approach based on the ratio of short-term external public debt to a country’s foreign exchange reserves is proposed. The conclusion is that decreasing the ratio of debt to reserves makes the restrictions imposed by the trilemma less harsh and also enables fuller realization of macroeconomic policy goals, an outcome confirmed by data from developing economies after the financial crisis.