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Working Paper No. 09-05
University of California, Santa Cruz Institute for International Economics (SCIIE), Santa Cruz, CA
Using the indexes we developed (Aizenman, Chinn, and Ito, 2008) to measure the degree of the three policy choices countries make with respect to the trilemma: exchange rate stability, monetary independence, and capital account openness, we investigate the normative questions pertaining to the trilemma, that is, how the policy choices among the three trilemma policies affect output growth volatility, inflation rates, and the volatility of inflation, with focus on developing economies. Some key findings for developing countries include: (i) greater monetary independence can dampen output volatility while greater exchange rate stability implies greater output volatility, which can be mitigated by reserve accumulation; (ii) greater monetary autonomy is associated with a higher level of inflation while greater exchange rate stability and greater financial openness could lower the inflation level; (iii) a policy pursuit of stable exchange rate while financial development is at the medium level can increase output volatility, and while greater financial openness with a high level of financial development can reduce output volatility, greater financial openness with a low level of financial development can be volatility increasing; (iv) net inflow of portfolio investment and bank lending can increase output volatility and higher levels of short-term debt or total debt services can increase both the level and the volatility of inflation.
impossible trinity
international reserves
financial liberalization
exchange rate
FDI flows
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Working Paper

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