Working Paper: NBER ID: w23440
Authors: Maurice Obstfeld; Alan M. Taylor
Abstract: In our book, Global Capital Markets: Integration, Crisis, and Growth, we traced out the evolution of the international monetary system using the framework of the “international monetary trilemma”: countries can enjoy at most two from the set {exchange-rate stability, open capital markets, and domestic monetary autonomy}. The events of the past decade or more highlight the further complications for this framework posed by financial stability issues. Here we update and qualify our prior analysis, drawing on recent experience and research. Under the classical gold standard, scant attention was paid to macro management, either to stabilize output and employment or to ensure financial stability. The interwar years highlighted the changing demands for modern central bank interventions in the economy. Financial instability, followed by WWII, left a world with sharply constricted financial markets and little private cross-border capital mobility. Due to this historical accident, the Bretton Woods system agreed in 1944 focused not at all on financial stability, and focused on issues like adjustment, exchange rate misalignment, and international liquidity (defined in terms of official, not private, capital-account transactions). Post 1970s floating rates permitted, but did not require, liberalization of the capital account. But the political equilibrium had shifted in favor of financial interests, signaled by the push toward European integration and the later reform process in emerging markets starting in the 1990s. This development, however, opened the door once again to domestic financial crises and their international transmission. Countries now become more susceptible to a new species of “capital account crises,” fueled by bank and bond lending, and its sudden withdrawal. These developments, in fact, made evident a different, “financial trilemma”: countries can pick at most two from {financial stability, open capital markets, and autonomy over domestic financial policy}. We distill the main lessons as to the interactions between the monetary and financial trilemmas, and policies that could best address the resulting weaknesses.
Keywords: International Monetary System; Financial Stability; Capital Markets; Monetary Policy
JEL Codes: B1; B2; E4; E5; E6; F3; F4; F6; G0; N1; N2
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policies (E63) | financial stability (G28) |
| international capital flows (F32) | domestic economies (D13) |
| monetary trilemma (E49) | financial conditions (E66) |
| exchange rate regimes (F33) | monetary policy effectiveness (E52) |
| floating exchange rates (F31) | buffer against external shocks (F32) |
| Bretton Woods system (F33) | financial stability challenges (F65) |
| pegged exchange rates and open capital accounts (F33) | higher interest rate correlations (E43) |