Evolution of the International Monetary System from the Perspective of Trilemma Challenges

The paper develops a new set of indexes of exchange rate stability (ERS), financial market openness (FMO), and monetary policy independence (MPI) to examine the issue of trilemma in international finance. It locates more than one hundred sample economies in the trilemma triangle over time—a useful way to illustrate the state and evolution of trilemma regimes. The paper argues that an important byproduct of using the Frankel-Wei and Kawai-Pontines methods to obtain the index of ERS, derived from the root mean squared error (RMSE) of regressions, is that they allow the identification of anchor currencies for individual economies as well as the computation of the size of major currency zones globally and regionally over time. The paper yields several interesting results. First, the global economic share of the U.S. dollar (USD) zone, still the largest in the world, has declined over time due to the emergence of the euro (EUR) zone and the recent rapid rise of the renminbi (RMB) zone. At the same time, the share of the world economy not belonging to any major currency zone — thus adopting flexible exchange rates— has expanded over time. Second, from the trilemma perspective,both advanced economies and emerging & developing economies have generally moved toward greater exchange rate flexibility and financial market openness, with some exceptions.Today, the number of economies adopting the “corner regime” of maintaining freely flexible exchange rates, open financial markets, and independent monetary policy is rising among both advanced and emerging & developing economies. On the other hand, no advanced economy adopts another “corner regime” of closed financial markets with high degrees of ERS and MPI. Very few emerging & developing economies select the third “corner regime” of no MPI with high degrees of ERS and FMO, while members of the Euro Area, which are essentially advanced economies, adopt this corner. Other economies choose non-corner regimes,including the “middle ground.” Finally, there is no single trilemma regime that delivers the best macroeconomic outcome for both advanced and emerging & developing economies.