Impossible trinity in a small open economy: A state-space model informed policy simulation

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

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

Abstract: Should monetary policy independence be maintained when the exchange rate is fixed under closed capital account conditions in a small open economy? We apply the Kalman filter at State Space model to test the Nepalese economy’s policy trilemma condition involving restricting capital flow, maintaining policy independence and fixing the exchange rate over the period 1989-2019. Accounting for two-thirds of Nepal’s total trade, Nepal is heavily trade-dependent to India in South Asia, which underwent economic liberalisation during the early 1990s. We modify the traditional Taylor-rule-based monetary policy reaction function to more closely represent Nepal’s economic characteristics by mixing backward-looking and forward-looking strategies and incorporating a fixed exchange rate in the monetary policy reaction function. The simulation results provide strong evidence of policy trilemma failure and inevitable policy trade-offs. In the monetary policy reaction function of both domestic and foreign conditions, the parameter value of domestic condition needs to be close to zero, to get the simulated interest rate close to observed. The loss of monetary policy independence raises a range of policy issues for the Nepalese economy: the rationale for fixing the exchange rate, and the efficacy of capital account closure which might deteriorate the effectiveness of monetary policy.

Keywords: Monetary Policy Independence; Impossible Trinity; State Space Model; Calibration; Policy Simulation (search for similar items in EconPapers)
JEL-codes: E47 E52 E58 (search for similar items in EconPapers)
Pages: 30 pages
Date: 2021-07
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-opm
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2021-60

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