Financial Adjustment in Small, Open Economies in Light of the “Impossible Trinity” Trilemma

Istvan Magas

Financial and Economic Review, 2018, vol. 17, issue 1, 5-33

Abstract: The study examines the resilience of small and open European economies to external shocks and the various types of financial integration adjustment in an empirical approach for the period between 1993 and 2016. External financial integration has been implemented in all of the examined countries, offering payment channels fully or largely open to foreign countries. The only major difference was in the level of monetary independence and foreign exchange rate stability. We were able to differentiate between two types of adjustment: in type A, financial policy was characterised by a greater level of monetary independence and a lower level of exchange rate stability, while countries that can be classified under type B practically gave up their monetary independence with their euro area membership, and opted for full exchange rate stability. But resilience to external shocks depends not only on the choices determined by the impossible trinity, but also on other macro-prudential factors, especially on the stability of budgetary processes and the repayment of external foreign currency debts. The difficulty to adjust, transcending beyond the limitations of the “trinity tradeoff”, was confirmed by the case of Portugal and Greece using the euro as their local currency, while the example of the non-euro area member Czech Republic illustrated a traditionally conservative, monetarily independent and successful external financial adjustment, built on flexible exchange rates and interest spreads. Hence there were many types of adjustment, where euro area membership in itself did not mean “bulletproof” protection in every respect. Hungary possibly joining the euro area would certainly improve its external financial resilience, but it would not make the existing competitiveness/development deficits disappear.

Keywords: monetary policy; shock resilience; exchange rate flexibility (search for similar items in EconPapers)
JEL-codes: F33 F36 F65 (search for similar items in EconPapers)
Date: 2018
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Citations: View citations in EconPapers (3)

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