Working Paper: CEPR ID: DP4353
Authors: Maurice Obstfeld; Jay C. Shambaugh; Alan M. Taylor
Abstract: The interwar period was marked by the end of the classical gold standard regime and new levels of macroeconomic disorder in the world economy. The interwar disorder is often linked to policies inconsistent with the constraint of the open-economy trilemma - the inability of policy-makers simultaneously to pursue a fixed exchange rate, open capital markets, and autonomous monetary policy. The first two objectives were linchpins of the pre-1914 order. As increasingly democratic polities faced pressures to engage in domestic macroeconomic management, however, either currency pegs or freedom of capital movements had to yield. This historical analytic narrative is compelling - with significant ramifications for today?s world, if true - but empirically controversial. We apply theory and empirics to the interwar data and find strong support for the logic of the trilemma. Thus, an inability to pursue consistent policies in a rapidly changing political and economic environment appears central to an understanding of the interwar crises, and the same constraints still apply today.
Keywords: exchange rates; monetary policy; trilemma
JEL Codes: F33; F41; F42; N10
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| trilemma constraints (D10) | monetary policy independence (E58) |
| type of exchange rate regime (fixed vs. floating) (F33) | degree of monetary sovereignty (E42) |
| countries with fixed exchange rates and open capital markets (F33) | loss of monetary sovereignty (E42) |
| domestic interest rates respond to changes in foreign base interest rates (E43) | monetary sovereignty (E42) |