Academic journal article Contemporary Economic Policy

Inside the Impossible Triangle: Monetary Policy Autonomy in a Credible Target Zone

Academic journal article Contemporary Economic Policy

Inside the Impossible Triangle: Monetary Policy Autonomy in a Credible Target Zone

Article excerpt

I. INTRODUCTION

Standard international macroeconomic theory posits that economic policy makers are confronted by three desirable objectives, which cannot be achieved simultaneously (Obstfeld, Shambaugh, and Taylor, 2005). The three objectives are (a) exchange rate stability (which is good for relative price stabilization purposes), (b) perfect capital mobility (which is good for efficiency and flexibility purposes), and (c) monetary policy autonomy (which is good for output stabilization purposes). Policy makers can opt for perfect versions of two items of this list but then have to completely give up on the third one. Intermediate regimes on all three dimensions are also possible. This fundamental trade-off is variously known in the literature as the trilemma or the inconsistent or impossible trinity/triangle. Using data spanning more than 130 yr, Obstfeld, Shambaugh, and Taylor (2005) present strong empirical support for the relevance of the trilemma over a broad range of countries, exchange rate regimes and degrees of international capital mobility.

As the trilemma acts as a constraint on macroeconomic policy choices, it is important to have an idea how stark the trade-offs are, especially inside the triangle (i.e., for intermediate regimes). After the financial crises of the 1990s, many observers have suggested that intermediate exchange rate regimes are disappearing (Eichengreen, 1994; Fischer, 2001). Frankel, Schmukler, and Serven (2001) use the notion of verifiability to argue that intermediate regimes suffer from more severe credibility problems than a corner solution. In this view, the rise of international capital mobility forces countries to choose either a hard peg (currency board, dollarization, or full monetary union) or freely floating exchange rates. This suggests that an intermediate exchange rate regime, such as a target zone, is characterized by a particularly unfavorable trade-off. On the other hand, Calvo and Reinhart (2002) found that there is widespread "fear of floating" and that intermediate exchange rate regimes predominate in practice. Countries that officially declare to have a free float often behave as if the regime is less flexible. This observation suggests that the trade-off is good for an intermediate regime but bad in the free-float corner of the triangle.

In the debate on the European Economic and Monetary Union (EMU), similar positions can be observed. Wyplosz (1997) argued that the complete abolition of capital controls in particular made the move to monetary union practically unavoidable. Obstfeld and Rogoff (1995) concluded that "there is little comfortable middle ground between floating rates and the adoption by countries of a common currency." On the other hand, many economists have pointed out that the euro area is not an optimum currency area and that the degree of asymmetry of economic shocks may be large. The complete loss of monetary autonomy and the exchange rate as a shock absorber implied by the transition from a target zone to EMU may therefore amount to a substantial cost in terms of macroeconomic stabilization capabilities (Edwards and Levy Yeyati, 2005; Feldstein, 1997; Obstfeld, 1998; Organization for Economic Cooperation and Development, 1999).

Making a choice between exchange rate stability and monetary policy autonomy is a crucial issue for those European Union (EU) member states that have not yet adopted the euro, in particular the Central and Eastern European countries that acceded to the EU in recent years. (1) The new member states have committed themselves to striving toward eventual adoption of the euro upon fulfillment of the convergence criteria laid down in the Treaty of Maastricht (European Central Bank, 2003). (2) At some point following accession, new member states will join the exchange rate mechanism (ERM II) on account of the exchange rate criterion, which says that EMU candidates must maintain a stable exchange rate versus the euro without severe tensions for at least 2 yr before being able to join EMU. …

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