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Trilemma-Dilemma: Constraint or Choice? Some Empirical Evidence from a Structurally Identified Heterogeneous Panel VAR

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Abstract

We use a heterogeneous panel structural VAR approach to study the role of international financial integration in determining the effectiveness of monetary policy under different exchange rate regimes. In particular, we use the extent to which a country's monetary policy is able to create temporary deviations from uncovered interest parity as a policy-relevant measure of the degree to which the country is effectively integrated with international financial markets, and then correlate this measure to our estimates of the ability of monetary policy to induce temporary movements in commercial bank lending rates. We find that regardless of whether a country pursues fixed or floating exchange rates, the impact of monetary policy shocks on bank lending rates is diminished as the country becomes financially more integrated with the world economy. This is a direct implication of Mundell's trilemma for countries with fixed exchange rates, but not for floaters. For floaters, we find that the weaker effects on domestic interest rates under high integration are accompanied with stronger effects on the exchange rate. This also holds true for monetary shocks originating in ``core'' countries. These results provide a possible reconciliation between Rey's ``dilemma'' and Mundell's famous trilemma: because higher financial integration increases exchange rate volatility in response to foreign monetary shocks, countries in the periphery that seek to avoid such volatility are more likely to pursue monetary policies that shadow those of the core as they become more financially integrated with the core.

Suggested Citation

  • Peter J. Montiel & Peter Pedroni, 2018. "Trilemma-Dilemma: Constraint or Choice? Some Empirical Evidence from a Structurally Identified Heterogeneous Panel VAR," Department of Economics Working Papers 2018-08, Department of Economics, Williams College.
  • Handle: RePEc:wil:wileco:2018-08
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    Keywords

    Trilemma; exchange rates; financial integration; monetary policy; heterogeneous panel structural VAR;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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