Case Study
Lal
PolicyTrilemma_DallasFed.pdf
2 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2015 Annual Report
he most important concept in
international macroeconomics
may be the trilemma of interna-
tional finance (also called the
impossible trinity). The trilemma states that a
country cannot simultaneously have an open
capital account, a stable exchange rate and
autonomous monetary policy (Chart 1).
The trilemma is a constraint on mon-
etary policymaking in any country. The
United States has chosen to maintain an
independent monetary policy and an open
capital account, but as a result, the Federal
Reserve must allow the value of the dollar to
be market-determined. Countries in the euro
zone have opted to stabilize their exchange
rate, and they enjoy the free movement of
capital. But as a result, individual nations
no longer have an independent monetary
policy.1 Policymakers in China, on the other
hand, have chosen to stabilize the exchange
rate and maintain an independent monetary
policy; but to make this work, they need to
The Trilemma in Practice: Monetary Policy Autonomy in an Economy with a Floating Exchange Rate
t impose restrictions on international capital
flows.2
By the logic of the trilemma, if a central
bank allows its exchange rate to float, it
should have complete monetary autonomy.
While this is certainly true in theory, some
have begun to question whether it is actually
true in practice. In a recent paper, Rey (2013)
discusses the “global financial cycle,” which
is the fact that large swings in capital flows
into many emerging-market economies are
driven by global factors such as risk and risk
aversion in major developed markets. These
swings in capital flows are exogenous from
the point of view of the emerging market
receiving the capital, the author argues. For
many emerging-market economies, swings in
the global financial cycle make the trilemma
more of a dilemma. Without restrictions on
international capital flows, monetary inde-
pendence is not possible, even for a country
with a floating exchange rate.
The fact that a country with open capital
By J. Scott Davis
Policymakers must decide which one to give up
Enjoy free capital flow
Stabilize the exchange rate Have sovereign monetary policy
“For many emerging- market economies, swings in the global financial cycle make the trilemma more of a dilemma. Without restrictions on international capital flows, monetary independence is not possible, even for a country with a floating exchange rate.”
Chart 1 The Trilemma of International Finance
Globalization and Monetary Policy Institute 2015 Annual Report • FEDERAL RESERVE BANK OF DALLAS 3
markets loses monetary policy autonomy
when it adopts a fixed exchange rate is purely
mechanical. As discussed in Rey’s article,
swings in trade and capital flows increase
or decrease demand for a currency, and a
central bank that tries to maintain a stable
exchange rate must adjust currency supply
to ensure the exchange rate stays constant as
demand fluctuates. Adjusting the supply of
the currency means adjusting the size of the
central bank’s balance sheet and, thus, ac-
tions to hold down the value of the currency
are indistinguishable from accommodative
open-market operations.3
The loss of monetary autonomy when a
central bank does not try to maintain a fixed
exchange rate is less mechanical. Theoreti-
cally, without the constraint of trying to sta-
bilize the value of the exchange rate, a central
bank with a floating exchange rate can use
its balance sheet however it likes. Nonethe-
less, as shown by Davis and Presno (2014),
even when monetary policy is determined
optimally to maximize a domestic objective
function, optimal policy could still focus
on managing volatile capital inflows and
outflows. Calvo and Reinhart (2002) discuss
a “fear of floating,” where even central banks
that profess to follow a floating exchange rate
policy still actively intervene in foreign-ex-
change markets to manage the value of their
currency.
This is especially true in an environ-
ment where a country is subject to large and
volatile swings in capital flows. Even though,
in theory, the central bank has complete
monetary autonomy, in practice, its actions
to stabilize the economy in the face of large
and volatile swings in capital flows will mean
Chart 2 Fed QE Impacts Floating, Fixed Emerging-Market Exchange Rates Percent change, year over year
EME with fixed exchange rate
–40
–30
–20
–10
0
10
20
30
201420132012201120102009200820072006
All emerging markets (EME)
EME with floating exchange rate
SOURCES: International Monetary Fund; author’s calculations.
that the optimally chosen monetary policy
is nearly indistinguishable from a policy of
exchange rate stabilization.
To see how, in the face of large swings
in international capital flows, central banks
in countries with floating currencies can end
up following policies that mirror exchange
rate stabilization, we will examine the actions
of some major emerging-market central
banks during the global financial crisis and
subsequent recovery. The rapidly changing
fortunes of the emerging markets during
this period can be summed up by examining
the path of emerging-market exchange rates
(Chart 2).
The chart plots the value of the exchange
rate versus the U.S. dollar for a group of
emerging-market economies and for two
subgroups—one that actively attempts to
stabilize exchange rates and the other that
allows its currencies to float.4
Floating emerging-market currencies
went on a wild ride between 2008 and 2011.
The global financial crisis led to a global flight
to quality in which capital flows to emerg-
ing markets dropped sharply, leading to
exchange rate depreciation. However, as we
shall see, during the crisis, emerging-market
central banks with nominally floating cur-
rencies actively intervened in the foreign-
exchange market to prevent further exchange
rate declines. This intervention is akin to
contractionary monetary policy.
The recovery from the financial crisis
saw a return in those capital flows, and this
led to a sharp appreciation in emerging-
market currencies. It was during this period
that the term “currency wars” was first used.
It was initially coined by Brazilian Finance
Minister Guido Mantega in September 2010.
4 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2015 Annual Report
crisis. Net capital inflows (capital inflows mi-
nus capital outflows) into the major emerg-
ing-market economies are plotted in Chart 3.
The chart shows a dramatic fall in
emerging-market capital flows during the
darkest days of the financial crisis in 2008.
Just before the crisis, capital moved into
emerging markets at a rate of 3 percent of
gross domestic product (GDP). However, the
chart shows that in late 2008, these capital
flows reversed quickly. In late 2008, capital
was flowing out of emerging markets at a rate
of 3 percent of GDP, and for the subgroup of
countries with a floating exchange rate, this
rate of capital outflow exceeded 6 percent of
GDP.
Emerging-market capital flows rebound-
ed in the early days of the recovery, and
capital flowed into all emerging markets at a
rate of 3 percent of GDP from 2009 through
the first half of 2011.
The fundamental balance of payments
identity states that a country’s current ac-
count plus its capital and financial account
must equal the net change in central-bank
reserves. The current account measures the
net flow of capital into a country because of
currently produced goods and services. The
current account includes the trade balance
(exports minus imports) and the net income
from investments held abroad and also some
unilateral transfers such as remittances and
foreign aid.6 The capital and financial ac-
count measures the net flow of capital into a
country because of private capital transac-
tions (purchase or sale of stocks, bonds, etc.).
The sum of these two items measures the net
flow of capital coming into a country. If this
net flow is not equal to zero, it must end up as
an increase or a decrease in foreign-exchange
reserves held by the central bank.
The balance of payments identity en-
capsulates the forces of supply and demand
that determine the fundamental value of the
exchange rate. The supply is determined by
the central bank and the accumulation of
reserves on the central bank’s balance sheet;
the demand comes from two sources, the
current account and the capital and financial
Chart 3 Net Capital Inflows Volatile Among Floating-Rate Emerging Economies Percent of gross domestic product (two-quarter moving average)
EME with fixed exchange rate
201420132012201120102009200820072006
All emerging markets (EME)
EME with floating exchange rate
–8
–6
–4
–2
0
2
4
6
SOURCES: International Monetary Fund; author’s calculations.
“Many emerging- market policymakers worried that the ultra-accommodative monetary policies in the United States and throughout the developed world were leading to a sharp increase in capital flows into emerging markets.”
At the time, the Federal Reserve was about
to embark on a second round of quantitative
easing (QE).
Many emerging-market policymak-
ers worried that the ultra-accommodative
monetary policies in the United States
and throughout the developed world were
leading to a sharp increase in capital flows
into emerging markets. Abundant liquidity
released by programs such as quantitative
easing streamed into emerging markets,
chasing higher returns, which pushed up
the value of their currencies.5 However, we
shall see that central banks in countries with
floating currencies intervened in the foreign-
exchange market during this period to slow
the appreciation of their currencies. This
intervention by central banks with floating
exchange rates was nearly indistinguishable
from the intervention by central banks with
fixed exchange rates.
Capital Flows, Balance of Payments
and Exchange Rate Fluctuations
Dramatic capital flow swings into
emerging-market economies accompanied
the period surrounding the global financial
Globalization and Monetary Policy Institute 2015 Annual Report • FEDERAL RESERVE BANK OF DALLAS 5
account (for simplicity, from here on, we will
refer to the capital and financial account as
the capital account).
When the sum of the current and capital
accounts is greater than zero, there is excess
demand for the currency. This is referred
to as a balance of payments surplus, and it
puts upward pressure on the value of the
exchange rate. If the central bank does not
try to actively manage the exchange rate and
allows the currency to “float,” this upward
pressure leads to exchange rate appreciation.
When the exchange rate appreciates,
foreign goods and assets become cheaper
to domestic residents, and domestic goods
and assets become more expensive to foreign
residents. This change in relative prices in the
goods market causes the trade balance, and
thus, the current account balance, to fall. This
change in relative prices in the asset market
causes the capital account balance to fall. The
exchange rate will appreciate until the point
where the balance of payments is no longer
in surplus, the sum of the current and capital
accounts is equal to zero and there is no
excess demand that pressures the exchange
rate.
If, on the other hand, a country’s central
bank actively tries to manage the exchange
rate, it may respond to this excess demand
by increasing the supply of the currency.
By increasing the supply of the currency,
it expands the liabilities side of its balance
sheet. The central bank releases this newly
created currency into the market by buying
foreign-exchange reserves (usually bonds
denominated in U.S. dollars or some other
major “reserve” currency). This expands the
asset side of its balance sheet.
The path of emerging-market central
bank reserves over the past 10 years is plot-
ted in Chart 4. During the crisis, reserves fell
sharply in countries that followed a policy
of allowing their currencies to float. This fall
in reserves is a sign that, during the crisis,
central banks in these countries were actively
engaging in the foreign-exchange market
to support the value of their currencies by
decreasing their supply in the market. In
response to the sharp drop in capital inflows
plotted in Chart 2, these central banks could
have allowed the exchange rate to fall further
until equilibrium was reached, where the
sum of the current and capital accounts was
equal to zero. Instead, they chose to inter-
vene by drawing down reserves.
Furthermore, Chart 3 shows that, during
the recovery, these same central banks were
actively accumulating reserves. We saw ear-
lier how, during the recovery, there was a re-
versal in emerging-market capital flows and
there were large positive net capital inflows
into the emerging markets from the middle
of 2009 through the middle of 2011. Central
banks in all emerging markets—both those
that follow a policy of exchange rate stabiliza-
tion and those that allow their exchange rate
to float—accumulated a massive amount of
reserves, which grew at around 20 percent
per year during the period.
Capital inflows during the 2009 to 2011
period put upward pressure on the value
of emerging-market currencies. Central
banks that follow a policy of exchange rate
stabilization were mechanically accumulat-
ing foreign-exchange reserves to relieve this
Chart 4 Emerging-Market Central Banks Accumulate Reserves Before Crisis Percent change, year over year
EME with fixed exchange rate
201420132012201120102009200820072006
All emerging markets (EME)
EME with floating exchange rate
–20
–10
0
10
20
30
40
SOURCES: Haver Analytics; author’s calculations.
6 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2015 Annual Report
upward pressure. The chart shows that, at the
same time, central banks in countries that al-
low their exchange rates to float were also fol-
lowing a policy of accumulating reserves that
was nearly indistinguishable from countries
that fix their exchange rates.
Monetary Autonomy?
During the crisis, central banks in coun-
tries with a floating exchange rate intervened
heavily in the foreign-exchange market
and drew down reserves to stabilize their
exchange rates. During the recovery, when
capital inflows reversed, the same central
banks accumulated reserves to relieve some
of the upward pressure on their currencies.
The effect of this on central-bank balance
sheets is shown in Chart 5. The chart shows
that emerging-market central-bank balance
sheet growth slowed sharply during the
2008–09 period.
For countries that follow an exchange
rate stabilization policy, balance sheet
growth fell from 35 percent per year in
early 2008 to 10 percent per year by 2009. To
maintain a stable exchange rate in the face of
a sharp drop in capital inflows, central banks
in countries with a fixed exchange rate were
forced to slow the growth in their balance
sheets during the crisis. This is part of the
mechanical monetary tightening that is re-
quired to maintain a stable exchange rate and
is simply a consequence of the constraints on
monetary policy autonomy imposed by the
trilemma.
Countries that follow a policy of allowing
the exchange rate to float should have been
free to engage in monetary loosening during
this period. However, the chart shows that,
for this group of floaters, balance sheets went
from a 20 percent expansion in early 2008 to
a contraction of 15 percent in 2009. There-
fore, countries that allowed their exchange
rate to float and should have had complete
monetary autonomy still engaged in sharp
monetary tightening during the crisis.
Similarly, central banks in countries that
float their currencies rapidly expanded their
balance sheets during the 2010–11 recovery.
Chart 6 Post-Crisis M1 Money Supply Growth Similar Among Emerging Markets Percent change, year over year
EME with fixed exchange rate
201420132012201120102009200820072006
All emerging markets (EME)
EME with floating exchange rate
–40
–30
–20
–10
0
10
20
30
40
SOURCES: Haver Analytics; author’s calculations.
Chart 5 Emerging-Market Central-Bank Balance Sheet Growth Slows
Percent change, year over year
EME with fixed exchange rate
201420132012201120102009200820072006
All emerging markets (EME)
EME with floating exchange rate
–20
–10
0
10
20
30
40
SOURCES: Haver Analytics; author’s calculations.
Globalization and Monetary Policy Institute 2015 Annual Report • FEDERAL RESERVE BANK OF DALLAS 7
Central-bank balance sheets grew 10 to 20
percent per year between 2009 and 2011. The
rate of balance sheet expansion for central
banks with a fixed exchange rate is nearly
identical. At a time when policymakers
were talking about currency wars and fears
of overheating in many emerging markets,
emerging-market central banks in countries
with a floating exchange rate were following a
highly accommodative monetary policy.
The effect of this central-bank balance
sheet contraction and subsequent expansion
on M1 money supply growth in the emerg-
ing-market economies is shown in Chart 6.7
It illustrates how, in emerging markets with a
floating exchange rate, money growth slowed
sharply during the global financial crisis in
late 2008 and then increased sharply during
the 2009–11 period. It is interesting to note
that money growth has been nearly identical
in the two subgroups of emerging markets
since early 2010.
Regaining Lost Monetary Autonomy
It is important to note that a central bank
in an economy with a fixed exchange rate has
to intervene in the foreign-exchange market
by selling reserves in response to a capital
inflow decline and a balance of payments
deficit, but a central bank with a floating
exchange rate does not.
It is certainly true that a central bank
with a floating exchange rate can respond
to a drop in net capital inflows and retain
monetary policy independence by allowing
the exchange rate to depreciate to the point
where the sum of the current and capital ac-
counts is again zero. But in reality, the pain of
this balance of payments adjustment may be
too great, particularly in an environment of
volatile shifts in capital flows. A sharp drop in
capital inflows is also referred to as a “sudden
stop” and usually entails a sharp tightening in
credit in the economy. The central bank may
sell reserves to fill the gap left by this drop in
capital inflows. Even though this causes the
central bank’s balance sheet to shrink and is,
thus, contractionary monetary policy, it may
be worth it to stave off the effects of a sudden
“At a time when policymakers were talking about currency wars and fears of overheating in many emerging markets, emerging- market central banks in countries with a floating exchange rate were following a highly accommodative monetary policy.”
stop. Similarly, the central bank may respond
with expansionary monetary policy in re-
sponse to an increase, or a “surge,” in capital
inflows. Without central bank action to accu-
mulate foreign-exchange reserves, this surge
could lead to unwanted credit expansion
and an overheating economy. Knowing this,
a central bank with a floating exchange rate
may find it worthwhile to sacrifice monetary
independence and use its balance sheet to
“manage” this surge in capital inflows by ac-
cumulating foreign-exchange reserves.
With the aim of managing volatile
swings in capital inflows and retaining mone-
tary policy autonomy, a number of emerging-
market central banks have used capital-flow
management measures (capital controls) to
“manage” volatile capital flows while leaving
the size of the central-bank balance sheet un-
touched, thereby retaining monetary policy
autonomy. These are commonly described as
“sterilized” foreign-exchange interventions.
When discussing how a central bank will ad-
just its holdings of foreign-exchange reserves
and the direct effect on balance sheet size, we
are considering unsterilized intervention. If
instead a central bank adjusts the size of its
foreign-exchange holdings to keep the cur-
rency stable but at the same time performs
the exact opposite open-market operation in
the domestic bond market, it can then inter-
vene in the foreign-exchange market without
affecting the size of its balance sheet.
For instance, in response to an increase
in capital inflows that would push up the
value of the exchange rate, the central bank
absorbs those capital inflows by buying
foreign-exchange assets. In an unsterilized
intervention, it would finance the purchase
by expanding the liability side of its balance
sheet (i.e., “printing money”). In a sterilized
intervention, the central bank will instead
finance the purchase of foreign-exchange
assets by selling domestic-currency bonds
on its balance sheet, replacing one central
bank asset for another and leaving the overall
size of its balance sheet unchanged (i.e., a
foreign-exchange intervention without print-
ing money).
8 FEDERAL RESERVE BANK OF DALLAS • Globalization and Monetary Policy Institute 2015 Annual Report
But these two actions—buying foreign-
currency-denominated bonds and selling
domestic-currency-denominated bonds—
cause the interest rate on foreign-currency-
denominated bonds to fall and the interest
rate on domestic-currency bonds to rise.
If there are no capital account restrictions,
private investors will simply buy domestic-
currency bonds and finance them by selling
foreign-currency bonds. This is the exact
opposite of what the central bank is doing!
Without capital account restrictions, private
investors will act in a way to exactly offset any
sterilized intervention by the central bank,
rendering it ineffective. Consequently, absent
capital account restrictions, the only way to
effectively stabilize the value of the exchange
rate is through an unsterilized intervention,
which requires the central bank to adjust
the size of its balance sheet and, therefore,
entails the loss of monetary policy autonomy.
Chart 7 plots the GDP-weighted average
of the number of capital flow management
measures applied in the emerging-market
countries with a floating exchange rate dur-
ing the global financial crisis and subsequent
recovery. The chart shows that these mea-
sures were reduced in late 2008 in response
to the crisis. Emerging-market central banks
were trying to attract capital, not repel it.
The number of capital controls increased
significantly starting with the recovery in
the second half of 2009. This was during the
period when emerging markets were seeing
large capital inflows, and many emerging
markets responded by trying to block them
by using legal restrictions.
The evidence for the effectiveness of
capital controls is mixed. Klein (2012) and
Klein and Shambaugh (2015) argue that
permanent fixed capital controls (which
Klein refers to as “walls”) can be effective,
but temporary capital controls (which Klein
refers to as “gates”) are less effective.
However, many emerging-market
central banks with a floating exchange rate
have attempted to impose capital flow man-
agement measures over the past few years,
particularly during the recovery and surge of
capital inflows into emerging markets in 2009
to 2011. The fact that so many emerging-mar-
ket central banks turned to capital controls to
“manage” capital flows is an indication that
even though the exchange rate was allowed
to float, these central banks were finding that
their monetary autonomy was restricted. The
theory of the trilemma states that a country
with a floating exchange rate should have
complete monetary independence. But the
actions of many central banks over the past
few years show that in practice, in an envi-
ronment of volatile capital flows, monetary
independence is limited, even when an
exchange rate is allowed to float.
Notes 1 The trilemma is a constraint on monetary policymaking not only at the national level, but at the subnational level. Texas has a stable exchange rate vis-à-vis the other 49 states, and there is free movement of capital within the United States. As a result, the Federal Reserve Bank of Dallas cannot set monetary policy independently of the rest of the Federal Reserve System. 2 As Chinese policymakers begin to loosen these controls and allow greater international holding of the Chinese yuan, a feature of the recent decision to include the currency
Chart 7 Capital Controls in Emerging Markets with a Floating Exchange Rate Average number of capital control measures, normalized to 0 in first quarter 2007
0
.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
201220112010200920082007
SOURCE: “The Two Components of International Capital Flows,” by Shaghil Ahmed, Stephanie Curcuru, Frank Warnock and Andrei Zlate (2015), mimeo.
Globalization and Monetary Policy Institute 2015 Annual Report • FEDERAL RESERVE BANK OF DALLAS 9
in the Special Drawing Rights (SDR), they will be forced to either allow the currency to float or sacrifice monetary independence. 3 This describes an “unsterilized” foreign-exchange intervention by the central bank. In a “sterilized” interven- tion, the central bank intervenes in the foreign-exchange market without adjusting the size of its balance sheet. However, the sterilized intervention is only effective when sufficient capital flow restrictions are in place. This form of intervention is further explored later in this article as part of a discussion of how some emerging-market countries are resorting to capital controls to insulate themselves against swings in the global financial cycle. 4 Countries that fix their exchange rate are defined as ones that receive a score of 1–2 on the course classification scheme in Ilzetzki et al. (2008). Countries that float are ones that receive a score of 3–4 on this course classification scheme. 5 Whether programs like quantitative easing had such an effect on emerging-market currencies and interest rates is a topic of much controversy. Rey (2013) argues that quantita- tive easing has had such an effect. In a recent lecture, former Federal Reserve Chairman Ben Bernanke (2015) disagrees with this assessment. Bernanke’s argument is based partially on recent research from economists at the Board of Governors that argues that quantitative easing had no more of an effect on emerging-market currencies and financial markets than normal monetary loosening in the United States (Bowman, Londono and Sapriza, 2014). 6 This article focuses on the financial aspects of the current account, where the current account measures the net flow of capital coming into a country because of currently produced goods and services. The trade balance is the larg- est component in the current account. For more discussion of trade and its effect on exchange rates, see the article by Michael Sposi in this report. 7 M1 is the most liquid definition of money and includes currency in circulation as well as demand deposits and checking account balances.
References Bernanke, Ben S. (2015), “Mundell-Flemming Lecture: Federal Reserve Policy in an International Context,” (speech delivered at the 16th Jacques Polak Annual Research Conference, Nov. 5–6, 2015).
Bowman, David, Juan M. Londono and Horacio Sapriza (2014), “U.S. Unconventional Monetary Policy and Transmis- sion to Emerging Market Economies,” International Finance Discussion Paper no. 1109 (Washington, D.C., Federal Reserve Board, June).
Calvo, Guillermo A., and Carmen M. Reinhart (2002), “Fear of Floating,” Quarterly Journal of Economics 117(2): 379–408.
Davis, Scott, and Ignacio Presno (2014), “Capital Controls as an Instrument of Monetary Policy,” Globalization and Monetary Policy Institute Working Paper no. 171 (Federal Reserve Bank of Dallas, June).
Ilzetzki, Ethan O., Carmen M. Reinhart and Kenneth S. Rogoff (2008), “Exchange Rate Arrangements Entering the 21st Century: Which Anchor Will Hold?” (mimeo).
Klein, Michael W. (2012), “Capital Controls: Gates vs. Walls,” NBER Working Paper no. 18526 (Cambridge, Massachusetts, National Bureau of Economic Research, November).
Klein, Michael W., and Jay C. Shambaugh (2015), “Round- ing the Corners of the Policy Trilemma: Sources of Monetary Policy Autonomy,” American Economic Journal: Macroeco- nomics 7(4): 33–66.
Rey, Hélène (2013), “Dilemma Not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” (paper prepared for the Jackson Hole Symposium, Aug. 23–25, 2013).
