Mundell’s trilemma: Policy trade-offs within the middle ground

Mundells’s trilemma makes strong categorial predictions on monetary policy trade-offs, where a small economy either has to adopt floating exchange rates or a closed capital account to establish interest rate autonomy. However, the trilemma is silent about a functional description of respective trade-offs for intermediate ‘middle ground’ policies. Accounting for the entire space of such policies, we study monetary autonomy in an unrestricted and continuous manner for 20 (mostly) developed economies. Evidence suggests that interest rate dependence almost linearly increases with the FX stability indicator under financial openness. Thereby, full independence would require an intensity of FX volatility which policymakers might hardly accept. However, this strong trade-off can be relaxed efficiently by a moderate reduction of financial openness. Hence, such a policy might offer some protection against the global financial cycle and leaves a considerable scope to combine a domestic monetary policy with a reduced FX rate variability.