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

Peter Montiel and Peter Pedroni

No 2018-08, Department of Economics Working Papers from Department of Economics, Williams College

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.

Keywords: Trilemma; exchange rates; financial integration; monetary policy; heterogeneous panel structural VAR (search for similar items in EconPapers)
JEL-codes: E52 E58 F36 (search for similar items in EconPapers)
Pages: 36 pages
Date: 2018-08
New Economics Papers: this item is included in nep-mac and nep-mon
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Forthcoming in Open Economies Review.

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Journal Article: Trilemma-Dilemma: Constraint or Choice? Some Empirical Evidence from a Structurally Identified Heterogeneous Panel VAR (2019)
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