Abstract:
The global financial economy limits the macroeconomic policy options of a country with the trilemma
constraints. Such an open economy has to choose between three desirable policy measures i.e., autonomous
monetary policy structure, open financial account, and a stable foreign exchange rate system for it is
impossible to have all three policies at a time. The trilemma constraint limits the ability of macroeconomic
policymakers in a country to achieve all three required policy options to stabilize the economy. However,
the Central bank of a country is one such institution that plays a crucial role in balancing the tradeoff among
the trilemma policy options and mitigating the effects that they may cause on the economy of the country.
In this regard, the active policy of reserve control and intervention allows the central bank to have stable
exchange rates, an independent monetary system, and free capital mobility at the same time. The foreign
exchange intervention by the central bank can effectively relax the trilemma constraint for a country. This
study has empirically analyzed the trilemma constraint for Pakistan for a sample period 1972-2020 and the
result shows that the trilemma constraint is binding. Also, by employing seemingly unrelated regression
(SUR) estimation and linearity checks the joint determinants of trilemma policies are evaluated and findings
are consistent with the theoretical considerations. Further, two measures of exchange market interventions
have been empirically employed and the results show that the active use of policy tools by the central bank
through foreign exchange intervention, the weighted sum of the three policy goals attains a higher value
and the trilemma constraint is relaxed. Lastly, the intuitive result that the trilemma space is not fully
exhausted in Pakistan needs consideration by the macroeconomic policymakers as there is room for the
attainment of the unutilized trilemma space through the introduction of policies favoring the three trilemma
policy goals.
