Trilemma across countries - a review of the trade-off

The trilemma problem from the Mundell-Fleming framework states that a country simultaneously may choose any two, but not all, of the following three goals: monetary independence, exchange rate stability and financial integration. Aizenman, Ito, and Chinn (AIC) in the NBER paper 14533 Assessing the emerrging global financilal architecture: Measuring the trilemma's configurations over time provides a useful framework for describing countries based on a four point criteria included in the Mundell-Fleming framework with the level of international reserves (IR/GDP) as a fourth dimension. AIC provides a diamond chart as a means of showing the trade-off of the three dimensions of the trilemma and the fourth dimension of the IR/GDP ratio. The four diamond approach can be normalized to provide a relative ranking vector for the exchange rate environment for each country. In each diamond chart, the origin is normalized so as to represent zero monetary independence, pure float, zero international reserves and financial autarky.

The review by AIC concludes that there has been an increase exchange rate flexibility and deeper financial flexibility especially for developing countries. There also has been a decrease in monetary independence but an increase in international reserves for developing countries. The use of greater international reserves is especially pronounced for emerging Asia.

The trilemma is not a set of hard choices but a set of trade-offs on the margin. More financial integration will lead to a loss of monetary independence and more exchange rate flexibility. These trade-offs can be measured to show that change in policy choices through time. The trade-off can be measured through trilemma indices.

Monetary Independence - Independence is based on the correlation between money market rates for a home and base country. A high correlation will mean higher dependence.

Exchange rate stability -To measure exchange rate stability, annual standard deviations of the monthly exchange rate between the home country and the base country are calculated to account for both the volatility and overall direction of exchange rates.

Financial openness/integration - Capital account openness as developed by Chinn and Ito and called KAOPEN is based on information regarding restrictions in the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER).

International reserves (IR) - IR/GDP hoarding acts as a buffer stock to help control exchange rates in a crisis. Almost 3/4th of all global reserves are now with developing countries. It acts as a form of self-insurance against sudden stops in global finance especially when there is greater financial integration.

The conclusions of AIC provide a nice frameowrk for thinking about exchange rate behvaior,

The recent trend suggests that among developing countries, the three dimensions of the trilemma configurations: monetary independence, exchange rate stability, and financial openness, are converging towards a “middle ground” with managed exchange rate flexibility, which they attempted to buffer by holding sizable international reserves, while maintaining medium levels of monetary independence and financial integration. Industrialized countries, on the other hand, have been experiencing divergence of the three dimensions of the trilemma and moved toward the configuration of high exchange rate stability and financial openness and low monetary independence as most distinctively exemplified by the euro countries’ experience.

We also tested whether the three macroeconomic policy goals are “binding” in the context of the impossible trinity. That is, we attempted to provide evidence that countries have faced the trade-offs based on the trilemma. ... Our results confirmed that countries do face the binding trilemma. That is , a change in one of the trilemma variables would induce a change with the opposite signin the weighted average of the other two.