Managed exchange rate regimes and monetary independence: an empirical appraisal

Under the impossible trinity, it is alleged that attempts to maintain both monetary independence and an undervalued domestic exchange rate whilst being exposed to global capital flows will culminate in macroeconomic instability. To analyse the validity of the impossible trinity in the instance of a balance of payments surplus, we first employ a number of ARDL models to investigate the potential presence of co-integration between foreign reserves and several variables on the balance sheet of the Central Bank. A VECM is then used to exemplify the fact that policymakers must respond to an increase in foreign reserves so as to steer the interbank rate to the policy rate. In total, we argue that in the case of a balance of payment surplus (i) it is problematic to validate the existence of a transmission mechanism between foreign reserve accumulation and inflation; (ii) economies with heavily managed exchange rates appear to have achieved monetary independence whilst remaining open to global capital flows; and finally, (iii) since the four Central Banks examined target an overnight rate, rather than any form of monetary aggregate, ‘exogenous’ sterilisation initiatives are involuntary.