Financial Trilemma and monetary policy

This Liberty street (FRBNY) post says that monetary policy makers should take financial conditions into account. Risk premiums are low when the natural interest rate is high. The natural rate is high when economic conditions are booming. Therefore, when the risk premiums are low (i.e., investor exuberance is high), central banks must bring down the natural rate of interest and that means that they have to dampen economic activity. Bingo! They have to raise the policy rate.

Interesting to note the manner in which the conclusions are presented. But, the fuller meaning is unmistakable. The new IMF Working Paper on Capital Account Liberalisation and Inequality concludes:

First, the impact of liberalization on inequality is smaller for countries with higher levels of financial development and inclusion. Second, the impact is also smaller in cases where the liberalization is not followed by a crisis. [Short Link and full paper link]

A very good blog post in ‘Economonitor’ that summarises the extant research on monetary policy trilemma or dilemma and introduces readers to the financial trilemma. One supposes that ‘Financial Trilemma’ is what Hélène Rey had in mind when she spoke of trilemma being effectively only a dilemma (two choices), regardless of the exchange rate regime.


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