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Testing 'the trilemma' in post-transitional Europe: a new empirical measure of capital mobility

Listed author(s):
  • Tomislav Globan

    ()

    (Faculty of Economics and Business, University of Zagreb)

This paper develops a new empirical measure of capital mobility. It tests the hypothesis that the degree of capital mobility can be estimated by measuring the reaction intensity of capital flows to shocks in interest rates, on a sample of eight European post-transitional economies. This hypothesis can be derived from the Mundell-Fleming open economy model, implications of which are essentially based on the assumption of a close link between the degree of capital mobility in a country and the reaction of its capital flows to changes in domestic and external interest rates. Precisely because of this interrelationship, policy holders, in theory, face the policy trilemma or the 'impossible trinity', i.e. the inability to achieve three following objectives simultaneously – a stable exchange rate, financial openness, and an independent monetary policy. Using impulse response and historical decomposition analysis in a VAR framework, the results show a significant increase in the explanatory power of interest rates for the movement of capital flows shortly before and after the accession of post-transitional economies to the European Union. On the other hand, the recent financial crisis made capital flows less sensitive to interest rates due to increased risk aversion on international capital markets. Results suggest that the degree of capital mobility, i.e. the level of financial integration with EU-15, is highest in Bulgaria, Latvia and Lithuania, and least pronounced in Poland and Croatia. Results are verified by a number of robustness checks, with three separate alternative measures of capital mobility confirming the results obtained from the econometric model.

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Paper provided by Faculty of Economics and Business, University of Zagreb in its series EFZG Working Papers Series with number 1407.

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Length: 35
Date of creation: 21 Nov 2014
Handle: RePEc:zag:wpaper:1407
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