Monetary policy spillovers and the trilemma in the new normal: Periphery country sensitivity to core country conditions

Joshua Aizenman, Menzie Chinn, Hiro Ito

09 July 2015




The integrated nature of the financial system was amply demonstrated by the turmoil in emerging market currency markets and bond markets in the wake of Fed Chairman Ben Bernanke’s statements regarding the normalisation of US monetary policy, commonly termed the ‘taper tantrum’. Following close on the heels of complaints about unconventional monetary policy implementation in the preceding years, it is clear that – at a minimum – policymakers in emerging market economies perceive an increasing vulnerability to the whims of the global financial system.

The idea that the monetary policies of financial centre countries have large spillover effects on the smaller economies is not new. During the mid-1990s, when advanced economy central bankers raised policy rates after several years of negative real interest rates, similar complaints were lodged. Some may partly trace the financial crises in Latin America and subsequently in East Asia to the cycle in core country policy interest rates. One key difference is that in the earlier episode’s aftermath, the semi-fixed exchange rate regimes were tagged as a contributing factor. In contrast, countries adhering to a variety of exchange rate regimes all experienced challenges in insulating their economies in the most recent episode. This has led to a grand debate about the continued relevance of the ‘impossible trinity’ or ‘monetary trilemma’.

Since Mundell (1963) outlined the hypothesis of the monetary trilemma, fundamental policy management in the open economy has been viewed as a trade-off between the choices of monetary autonomy, exchange rate stability, and financial openness.1 The hypothesis and its extensions in recent years suggest a continuous trade-off between the three trilemma dimensions, with the possibility that a fourth policy goal. The fourth goal of financial stability may augment the trilemma, turning it into a quadrilemma where international reserves may play a role as buffers.

In contrast, in the aftermath of the Global Crisis, Rey (2013) concluded that the economic centre’s monetary policy influences other countries’ national monetary policy. That happens mostly through capital flows, credit growth, and bank leverages, making the types of exchange rate regime of the non-centres irrelevant. In other words, the countries in the periphery are all sensitive to a ‘global financial cycle’ irrespective of their exchange rate regimes. In this view, the ‘trilemma’ reduces to an ‘irreconcilable duo’ of monetary independence and capital mobility. Consequently, restricting capital mobility maybe the only way for non-centre countries to retain monetary autonomy. The recent experience of Brazil, India, Indonesia, South Africa, and Turkey – the ‘fragile five’ – during the ‘taper tantrum’ may make the irreconcilable duo view convincing.

How the monetary policy of centres affects the monetary policy of other countries: New evidence

In a recent paper, we investigate whether Rey prematurely predicted the end of the trilemma (Aizenman et al. 2015). Inferences based on data drawn from times of heightened volatility emanating from the centre might be modified once we examine how the propagation of large shocks from the centre can be affected by economic structures and measures of the trilemma variables. In a world of more than 100 countries, one ignores heterogeneity at one’s own risk. For instance, the trade-offs facing the OECD countries may differ from those facing manufacturing-based or commodity-based emerging economies and developing countries.2 Furthermore, large shocks arising from the EC during the Global Crisis and the Eurozone Crisis may have altered the transmission dynamics, especially in comparison to the preceding decade of illusory tranquillity.

Figure 1 illustrates the 36-month rolling correlations of domestic money market rates with the US money market rate for developed countries (IDC), developing countries (LDC), and emerging market economies (EMG), and China, from 1990 to 2013. For developed economies, the correlation between domestic and the US policy interest rates is high and hovers at relatively high levels in the last decade. In contrast, developing countries tend to retain high monetary independence from the US, while emerging market monetary policy independence occupies a middle ground. All the correlations fluctuate, but experience two pronounced dips in recent years, one in 2005 and the other at the time of the Global Crisis. These two dips correspond to rapid changes in the US Federal funds rate.3

Figure 1. Correlations of the short-term interest rates with the US

Figure 2 depicts correlations of long-term interest rates. Again, the long-term interest rates of industrialised countries register high correlations with that of the US, particularly in the first half of the sample period, though the correlation has been on a rising trend again in recent years. Developing countries experience relatively high correlations in the early 2000s, but since the late 2000s the correlations appear to exhibit no trend. Long-term interest rates across countries – including both developed and developing countries – were highly correlated during the Great Moderation period.

Figure 2. Correlations of the long-term interest rates with the US

Figure 3 is an interesting picture. It illustrates the comparable correlations of stock market price indexes (expressed in local currency) with the US index. Since the mid-2000s, all the country groups have maintained high levels of correlations of stock market price indexes with the US stock market, with some tail-off since the Global Crisis.

Figure 3. Correlations of the stock market price indexes with the US

What do these figures tell us? Broadly speaking, the extent of correlations is highest for stock market price movements, followed by the long-term and short-term interest rates. Given short-term interest rates bear the lowest levels of risk, we may conjecture that the prices of assets with higher risk tend to be more highly correlated with that of the US. Of course, these graphical depictions do not provide conclusive evidence, particularly since we have not controlled for any number of important factors, e.g. the policy regimes, macroeconomic conditions, the extent of trade linkage, the level of institutional development and size of financial markets, and global market conditions. Many studies such as Ahmed and Zlate (2013), Forbes and Warnock (2010), Fratzscher (2011), and Ghosh et al. (2012) have documented the importance of global factors such as advanced economy interest rates and global risk appetite in affecting capital flows to small open economies. Nonetheless, these studies have also highlighted that domestic, country-specific factors retain importance. In particular, the institutional and macroeconomic policy frameworks of the emerging market economies could determine the variations in flows.

Empirical analysis on what determines sensitivity to the core economies

Given this context, we focus on the questions of why movements in the major advanced economies often have large effects on other financial markets, how these cross-market linkages have changed over time, and what kind of factors contribute to explaining the sensitivity to the movements in the major economies. More specifically, we conduct an empirical analysis on what determines the sensitivity of economies to factors pertaining to the core economies in the world, namely, the US, the Eurozone, Japan, and China. For the last two decades, the Chinese economy has been growing at impressive rates and quickly moving upward on the development ladder. However, its financial markets may not be developed or sophisticated to the extent of becoming the centre of global financial cycles. Despite data limitations as well as China’s relatively short tenure as one of the G3 countries, we also examine whether our results are sensitive to the inclusion of China as one of the centre economies.

For our empirical exploration, we employ an estimation process similar to that of Forbes and Chinn (2004), which is composed of two steps. First, we investigate the degree of sensitivity of several important financial variables to global, cross-country, and domestic factors. Second, treating the estimated sensitivity as a dependent variable, we examine its determinants among a number of country-specific variables. In so doing, we disentangle roles of countries’ macroeconomic conditions or policies, real or financial linkage with the centre economy, or the level of institutional development of the countries.


  • We find that for most of the financial variables we examine, the strength of the links with the centre economies have been the dominant factor over the last two decades.

The influence of global financial factors, for which we use VIX and Ted spread, has been increasing since around the time of the Global Crisis.

  • The results we obtain suggest that across different financial linkages, higher levels of direct trade linkage, financial development, and gross national debt all tend to lead to stronger financial linkages between the sample countries and the three centre economies.

Open macro policy arrangements such as the exchange rate regime and financial openness also affect the extent of financial linkage both directly and indirectly, i.e. interactively with other macroeconomic or institutional variables. Specifically, we find that the types of exchange rate regimes do affect the extent of sensitivity to changes in financial conditions or policies in the centre economies. Rey’s (2013) result may reflect the dominance of the US leverage and deregulation policies that contributed to the Crisis, as well as the dominance of the US Fed’s policies in charting the onset of the tenuous recovery from the Global Crisis. While there is no way for emerging markets to hide from the policies and challenges of the core, the details of the transmission of shocks and the resultant volatility are determined by the trilemma logic. Hence, the open macro policy choice is ‘still’ dictated by the hypothesis of the trilemma.[4] Therefore, the news about the irrelevance of exchange rate changes may have been exaggerated.


Ahmed, S and A Zlate (2013), “Capital Flows to Emerging Market Economies: A Brave New World?” Board of Governors of the Federal Reserve System International Finance Discussion Papers, #1081, Washington, DC: Federal Reserve Board (June).

Aizenman, J, M D Chinn, and H Ito (2015), “Monetary Policy Spillovers and the Trilemma in the New Normal: Periphery Country Sensitivity to Core Country Conditions,” NBER Working Paper No. 21128.

Aizenman, J and H Ito (2013), Forthcoming in the Journal of International Money and Finance, Also available as NBER Working Paper #19448 (September 2013).

Aizenman, J, M D Chinn, and H Ito (2011), “Surfing the Waves of Globalization: Asia and Financial Globalization in the Context of the Trilemma,” Journal of the Japanese and International Economies, Vol 25(3), p 290 – 320 (September).

Aizenman, J, M D Chinn, and H Ito (2010), “The Emerging Global Financial Architecture: Tracing and Evaluating New Patterns of the Trilemma Configuration,” Journal of International Money and Finance 29 (2010) 615–641.

Forbes, K J and M D Chinn (2004), “A Decomposition of Global Linkages in Financial Markets over Time”, The Review of Economics and Statistics, August, 86(3): 705–722.

Forbes, K J and F E Warnock (2012), “Capital Flow Waves: Surges, Stops, Flight, and Retrenchment”, Journal of International Economics, 88(2), 235-251.

Fratzscher, M (2011), “Capital Flows, Push Versus Pull Factors and the Global Financial Crisis”, NBER Working Paper 17357.

Ghosh, A R, J Kim, M Qureshi, and J Zalduendo (2012), "Surges", IMF Working Paper WP/12/22.

Gourinchas P O and H Rey (2014), “External Adjustment, Global Imbalances, Valuation Effects,” in Gopinath G, E Helpman and K Rogoff (eds)  Handbook of International Economics.

Mundell, R A (1963), “Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates”, Canadian Journal of Economic and Political Science, 29(4): 475–85.

Obstfeld, M (2014), “Trilemmas and Tradeoffs: Living with Financial Globalization”, mimeo, University of California, Berkeley.

Obstfeld, M, J C Shambaugh, and A M Taylor (2005), “The Trilemma in History: Tradeoffs among Exchange Rates, Monetary Policies, and Capital Mobility,” Review of Economics and Statistics 87 (August): 423–438.

Rey, H (2013), “Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence,” prepared for the 2013 Jackson Hole Meeting.

Shambaugh, J C (2004), “The Effects of Fixed Exchange Rates on Monetary Policy”, Quarterly Journal of Economics 119 (1), 301-52.


1 See Aizenman et al. (2010, 2011, 2013), Obstfeld (2014), Obstfeld et al. (2005), and Shambaugh (2004) for further discussion and references dealing with the trilemma.

2 For example, maintaining exchange rate stability could be more important for developing countries whose growth strategy is reliant on the exports of a narrower variety of manufactured goods or commodities than advanced economies with more diversified economic structures.

3 The Federal Reserve started raising the federal fund rate target from 1.00% in June 2004 to 5.25% in June 2006. It started lowering the target from 5.25% in September 2007 all the way to 0.00-0.25% by December 2008.

4 Gourinchas and Rey (2014) noted that valuation effects, which are capital gains and losses on gross external assets and liabilities (including exchange rate changes), account for an important and increasing part of the dynamics of countries’ net foreign asset positions.



Topics:  International finance Monetary policy

Tags:  monetary policy spillovers, centre economies, monetary policy

Dockson Chair in Economics and International Relations, USC, and Research Associate, NBER

Professor, Robert M. La Follette School of Public Affairs and Department of Economics, University of Wisconsin

Professor of Economics, Portland State University