Impossible Trinity in a Small Open Economy: A State–Space Model Simulation

Guna Raj Bhatta (), Rabindra Nepal, Kankesu Jayanthakumaran and Charles Harvie ()

Asian Development Policy Review, 2022, vol. 10, issue 3, 200-225

Abstract: Should monetary policy independence be maintained when the exchange rate is fixed under closed capital account conditions in a small open economy? In this study, we simulate the impossible trinity condition during 1989 to 2019 on the Nepalese economy that restricts capital flows and fixes the exchange rate with India. We modify the traditional Taylor rule based on the monetary policy reaction function to characterize Nepal's economic conditions more closely. The state–space model simulation shows that the policy trilemma does not hold in Nepal, such that the model can predict interest rate when the weight for domestic conditions is assigned at a substantially lower level. Therefore, the existing policy mix may need to be revisited to maintain monetary policy independence. Nepal might consider devaluing its currency to neutralize the adverse effects of the negative risk premium and ameliorate the real exchange rate appreciation in the short run and explore alternative arrangements in the long run.

Keywords: Monetary policy independence; Impossible trinity; State space model; Calibration; Policy simulation. (search for similar items in EconPapers)
Date: 2022
References: Add references at CitEc
Citations:

Downloads: (external link)
https://archive.aessweb.com/index.php/5008/article/view/4561/7159 (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:asi:adprev:v:10:y:2022:i:3:p:200-225:id:4561

Access Statistics for this article

More articles in Asian Development Policy Review from Asian Economic and Social Society
Bibliographic data for series maintained by Robert Allen ().