Effects of trilemma policies patterns on monetary policy credibility

Abstract

The open economy trilemma refers to the impossibility of a country fully and simultaneously achieving three political objectives: monetary policy independence, exchange rate stability and financial openness. However, corner configurations related to the three policies of the trilemma are increasingly rare. In fact, countries tend to choose a policy combination composed of partial financial integration, managed exchange rate flexibility and partial monetary independence. Given the possibility of intermediate choices, there exists an index able to measure the relative divergence (or convergence) regarding the policy choices of the trilemma. The index identifies whether countries are adopting similar (or divergent) policy mixes in relation to the trilemma policy options. However, the consequences of adopting a more (or less) convergent policy arrangement on monetary policy credibility are unknown. Hence, this study investigates the effects of trilemma policies convergence patterns on monetary policy credibility. The idea is to verify whether a more convergent arrangement of policies related to the trilemma in open economies helps build monetary policy credibility. Our database is formed by 94 (developed and developing) countries with different characteristics. Thus, we run estimates based on a family of Tobit models for different sub-samples of countries, and also considering different periods – before and after the Global Financial Crisis. The study brings important practical implications. In general, the findings show that a convergent strategy increases credibility. The estimates corroborate the idea that countries adopting divergent policies from the global standard tend to be more exposed to economic instability and, as a result, have difficulties in anchoring inflation expectations.