Monetary and fiscal policy impacts under alternative trilemma regimes

Abstract

Using a new set of trilemma indexes for exchange rate stability, financial market openness, and monetary policy independence, this paper first locates more than one hundred economies in the trilemma triangle over time. Second, the paper depicts individual economies’ trilemma regimes, defined by combinations of the three indexes, in the global map. Third, the paper tests econometrically the impact of monetary and fiscal policies on key macroeconomic variables (i.e., the real GDP growth rate gap, inflation, and their variability/volatility) under alternative trilemma regimes. Fourth, it examines the roles of trilemma regimes in influencing the macroeconomic variables. Econometric analysis uses a sample of 61 emerging market & developing economies over the period 1971–2020. The two-stage least squares estimation results largely support the Mundell-Fleming predictions made for three “corner” regimes. Monetary policy is effective in raising the real GDP growth rate gap and its variability under the “flexible exchange rate” corner regime, but not under the “financially open fixed rate” regime. Monetary policy is most effective in stimulating inflation and inflation volatility under the “flexible rate” regime. Fiscal policy has a positive impact on the GDP growth rate gap under the “flexible rate” regime and positive impacts on inflation and variability/volatility measures under the “financially closed fixed rate” regime, while it has no such impact under the “financially open fixed rate” regime, a somewhat surprising finding. The “financially open fixed rate” regime has a role of achieving price stability in a financially open economy.