How realistic is the concept of a “The Dilemma” of monetary policy in modern conditions for small open economies?

The classic Mundell-Fleming model established the concept of the “The Trilemma” or “Impossible Trinity.” According to economic theory, the term "trilemma" describes a situation, in which only two of the three goals can be achieved by the policymakers pursuing macroeconomic policy. It means that a country cannot simultaneously combine a fixed exchange rate, high capital mobility and an independent monetary policy. Since the global financial crisis due to financial support of advanced economies to developing countries, capital flows have been abundant. The massive inflow has made asset markets more sensitive to the global financial cycle. It was subsequently decided that the global financial cycle had turned "The Trilemma" into "The Dilemma" limiting the independence of monetary policy regardless of the exchange rate regime.

The authors' paper differs from previous studies on the topic in several respects. While most previous economists studied the US economy and global financial cycles are based on linear models, the current research focuses on small open economies in a nonlinear manner. The authors use New Zealand data from 1997 to 2020 and focus on the importance of capital flow volatility regimes. The study reveals how volatility in capital flows affects the economy.

The authors use New Zealand as a case study because this country is a key example of a small open economy where the rules of the "Impossible Trinity" concept can be applied. New Zealand is a developing country that has had a current account deficit for years. At the same time, in Kazakhstan the current account balance is also mainly in deficit. Only in 2022, for the first time in 7 years, the negative current account balance moved into a positive zone due to an improvement in the trade balance. Thus, both countries need capital inflows to finance the deficit.

Chart 1. Current account deficit of Kazakhstan and New Zealand, % of the country's GDP

Source: National Bank of Kazakhstan and Stats NZ

Since 1985, the Central Bank of New Zealand has followed a floating exchange rate regime and has conducted a policy of inflation targeting regime since 1989. The National Bank of the Republic of Kazakhstan (NB RK) began implementing the inflation targeting regime in 2015. The policymakers’ preference to an independent monetary policy and free movement of capital makes both Kazakhstan and New Zealand compelling examples of how “The Trilemma” behaves.

And on the basis of the characteristics of these countries taking into account the significance of the volatility rate of capital flows, we can also consider how “The Dilemma” works. New Zealand and Kazakhstan differ significantly in the volume of capital flows, as well as in their direction. Thus, over 6 years in Kazakhstan, the financial account balance developed with both a deficit and a surplus, while in New Zealand it always remained positive. However, the nature of the capital flow volatility regimes is similar: the values of the indicators vary greatly from year to year, which is especially clearly observed in Kazakhstan (see Chart 2).

Chart 2. Balance of financial accounts of Kazakhstan and New Zealand, million US dollars

Source: National Bank of Kazakhstan and Stats NZ

By using a two-regime model, describing different volatility regimes, the authors found that “The Dilemma” would always be a problem for a small open economy such as New Zealand (or Kazakhstan). Not only the volume of capital flow matters, but its volatility also has a significant impact. In addition, conducting an independent monetary policy will always face “The Dilemma” due to the inflow or outflow of capital. Capital inflows contribute to the exchange rate appreciation and accelerate credit growth, while capital outflows result in depreciation and higher inflation. These results imply that domestic interest rates are influenced by global interest rates. The authors conclude that in the long run within a high volatility regime more than 25 percent of the real exchange rate change is explained by the capital flow volatility shock.

The authors also find a stronger impact of monetary policy shocks under high volatility regimes. A contractionary monetary policy shock always promotes an appreciation of the exchange rate in a high-volatility regime, but does not always guarantee capital inflows. At the same time, such shock reduces the volatility of capital flows, but seriously slows down real GDP growth. Thus, one of the policy implications from the paper's findings is that monetary policy can be an effective tool for dealing with the volatility of capital flows.

In addition, one of the key findings is that central banks in small open economies will always face challenges related to global conditions. In particular, in the environment of high volatility of capital flows, dramatic changes in exchange rates affect the short-term dynamics of domestic interest rates. Moreover, the volatility of capital flows plays an important role not only in the short term, but in the long term.