Trilemma Policy Choices, Their Determinants, and the Role of the Central Bank in Mitigating Trilemma Effects for Pakistan

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.