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Are Small Countries Able to Set their Own Interest Rates? Assessing the Implications of the Macroeconomic Trilemma

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  • Helmut Herwartz
  • Jan Roestel
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    Abstract

    According to the ’macroeconomic trilemma’ the ability of small economies to pursue an independent monetary policy is jointly determined by country specific foreign exchange (FX) rate flexibility and capital mobility. In particular, free floating economies should be able to isolate domestic interest rates even under globalized capital markets. Recent evidence casts doubts if this gain in independence is substantial. Taking advantage of semiparametric functional regression models we study the trade-off among FX stability, capital mobility and monetary autonomy for a panel of 20 developed small economies. Confirming the macroeconomic trilemma, the exposure to foreign interest rates is found to increase with country specific states of exchange rate stability and capital mobility. Gains in monetary independence appear substantial for countries that abdicate to peg their FX rates, but the marginal benefit of tolerating higher exposure to FX volatility quickly vanishes. Free floating economies might therefore be able to moderately stabilize FX rates at little cost.

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    Bibliographic Info

    Paper provided by European University Institute in its series Economics Working Papers with number ECO2010/09.

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    Date of creation: 2010
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    Handle: RePEc:eui:euiwps:eco2010/09

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    Keywords: monetary independence; macroeconomic trilemma; monetary policy; exchange rate regime; interest rates; functional coefficients; semiparametric models;

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