Trilemma or Dilemma – Investigating Monetary Autonomy in the Era of Financial Globalization

This paper re-visits the monetary trilemma versus dilemma debate by empirically examining interest rate policy independence for a large sample of both advanced and developing countries over the time period 1973-2014. We broadly concur with the growing body of literature that suggests that the trilemma still holds, emphasizing the important insulating effects afforded by exchange rate flexibility. However, as with Han & Wei (2018), we also document the existence of an asymmetric pattern or 2.5-lemma between the trilemma and dilemma; though in contrast to them we find there seems to be evidence of “fear of capital reversal” rather than a “fear of appreciation”. We further find that interest rates of countries with high level of reserves tend not to co-move with base country interest rate even when the center countries tighten their monetary policy stances, while countries with low reserve levels closely follow the base country rate and tighten their monetary policy as well. This suggests that holding higher levels of reserves may help convert the 2.5-lemma back into a trilemma. We further find that while completely flexible exchange rates allow a country to maintain monetary policy autonomy, intermediate degrees of flexibility do not seem to do so. However, partial capital account openness seems to work just as well as having a completely closed capital account. We also find that while macroprudential policies (MaPs) cannot substitute for capital controls, they may help circumvent the trilemma constraints and insulate a country with an open capital account from foreign monetary shocks.