The Mundellian Trilemma and Optimal Monetary Policy in a World of High Capital Mobility

Richard T. Froyen and Alfred Guender

Working Papers in Economics from University of Canterbury, Department of Economics and Finance

Abstract: This paper proposes that the Mundellian Trilemma remains valid despite the emergence of a world financial cycle. A clear distinction must be made between monetary policy independence and insulation of an open economy’s financial system. A flexible exchange rate allows an optimizing central bank to chart an independent course but does not insulate the domestic economy from foreign monetary or financial shocks. The gains from a flexible exchange rate may be considerable and vary in accordance with the mandate of the central bank. The Mundellian Trilemma highlights the acute shortage of policy instruments and resulting tradeoffs among policy goals. We show that macroprudential policy in the form of an interest equalization tax, enhances the ability of an optimizing central bank to effectively stabilize domestic output and inflation in the presence of policy changes abroad and potentially destabilizing capital flows.

Keywords: Mundellian Trilemma; policy independence; capital mobility; instrument shortage; capital controls (search for similar items in EconPapers)
JEL-codes: E3 E5 F3 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2021-09-01
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
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https://repec.canterbury.ac.nz/cbt/econwp/2108.pdf (application/pdf)

Related works:
Journal Article: The Mundellian Trilemma and Optimal Monetary Policy in a World of High Capital Mobility (2022)
Working Paper: The Mundellian trilemma and optimal monetary policy in a world of high capital mobility (2021)
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Persistent link: https://EconPapers.repec.org/RePEc:cbt:econwp:21/08

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