Public Affairs 854 Menzie D. Chinn Spring 20 13 Social Sciences 7418 University of Wisconsin-Madison The Trilemma, aka the “Impossible Trinity” http://www.brookings.edu/papers/1999/06development_frankel.aspx Figure 1: Definitions of Nine Major Exchange Rate Regimes, Ranged Along the Continuum from the Most Flexible to the Strongest Fixed-Rate Commitment FLEXIBLE CORNER 1. Free floating--the absence of regular intervention in the foreign exchange market 2. Managed float--the absence of a specific target for the exchange rate INTERMEDIATE REGIMES 3. Target zone, or band--a margin of fluctuation around some central rate 4. Basket peg--fixing not to a single foreign currency but to a weighted average of other currencies 5. Crawling peg--a preannounced policy of devaluing a bit each week 6. Adjustable peg--fixing the exchange rate, but without any open-ended commitment to resist devaluation or revaluation in the presence of a large balance of payments deficit or surplus FIXED CORNER 7. Truly fixed peg--fixing, committing to buy or sell however much foreign currency is necessary at a given exchange rate, with a firm and lasting intention of maintaining the policy 8. Currency board--three defining characteristics: fixing not just by policy but by law, backing increases in the monetary base one-for-one with foreign exchange reserves, and allowing balance of payments deficits to tighten monetary policy and thereby adjust spending automatically 9. Monetary union--the adoption of a foreign currency as legal tender. This includes the special case of official dollarization Figure 1: The Trilemma and International Reserves Configurations over Time Industrialized Countries Non-Euro Industrialized Countries Monetary Independence Monetary Independence Financial Integration Exchange Rate Stability Financial Integration Exchange Rate Stability .2 .2 .4 1971-80 .4 1971-80 .6 1981-90 .6 1981-90 1991-2000 1991-2000 .8 2001-06 .8 2001-06 1 1 International Reserves/GDP International Reserves/GDP Center is at 0 Center is at 0 Emerging Market Countries Non-Emerging Market Developing Countries Monetary Independence Monetary Independence Financial Integration Exchange Rate Stability Financial Integration Exchange Rate Stability .2 .2 .4 1971-80 .4 1971-80 .6 1981-90 .6 1981-90 1991-2000 1991-2000 .8 2001-06 .8 2001-06 1 1 International Reserves/GDP International Reserves/GDP Center is at 0 Center is at 0 Latin America Developing Asia Monetary Independence Monetary Independence Financial Integration Exchange Rate Stability Financial Integration Exchange Rate Stability .2 .2 .4 1971-80 .4 1971-80 .6 1981-90 .6 1981-90 1991-2000 1991-2000 .8 2001-06 .8 2001-06 1 1 International Reserves/GDP International Reserves/GDP Center is at 0 Center is at 0 Emerging Latin America Emerging Asian Economies Monetary Independence Monetary Independence Financial Integration Exchange Rate Stability Financial Integration Exchange Rate Stability .2 .2 .4 1971-80 .4 1971-80 .6 1981-90 .6 1981-90 1991-2000 1991-2000 .8 2001-06 .8 2001-06 1 1 International Reserves/GDP International Reserves/GDP Center is at 0 Note: This sample includes Taiwan, HK, Indonesia, Korea, Malaysia, Philipines, Singapore, Thailand, China NOTES: “Emerging Asian Economies” include China, Hong Kong, Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan, and Thailand. “Emerging Latin America” includes Argentina, Brazil, Chile, Colombia, Ecuador, Jamaica, Mexico, Peru, Trinidad and Tobago, and Venezuela. Source: Aizenman, Chinn, and Ito, “The Emerging Global Financial Architecture,” mimeo (March 2009). 1.0 0.9 LDC cait = ρ + ρ −110 + vca itit LDCex.-oil 0.8 0.7 0.6 0.5 0.4 0.3 Float Dirty Float Dirty Float/ Fixed Crawling Peg AR1 coefficients for CA/GDP 1.0 0.9 LDC LDCex.-oil 0.8 0.7 0.6 0.5 0.4 0.3 Float Dirty Float Dirty Float/ Fixed Crawling Peg AR1 coefficients for CA/GDP, with openness as covariate 1.0 0.9 0.8 0.7 LDC LDC ex.-oil 0.6 0.5 0.4 0.3 Float Dirty Float Dirty Float/ Fixed Crawling Peg AR1 coefficients for real effective exchange rate, with openness as covariate Source: Chinn and Wei, “A Faith-based Initiative: Do We Really Know that a Flexible Exchange Rate Regime Facilitates Current Account Adjustment?” mimeo (March 2009). Pa854_trilemma_s13 .