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• Feng Zhu
  Bank for International Settlements

This paper assesses the empirical validity of the trilemma (or impossible trinity) hypothesis in the period after the global financial crisis, for a large sample of advanced and emerging economies. We find that monetary policy in economies with extensive exchange rate flexibility has been strongly correlated with monetary policy in the base-country, even after controlling for synchronised business cycles, common shocks and macroeconomic spillovers. Moreover, our results suggest that the failure of extensive exchange rate flexibility to enhance monetary policy autonomy is primarily due to “fear-of-floating”, underpinned by high exchange rate pass-through to consumer prices as well as the financial channel of exchange rates. Consistent with the latter finding, we document that the existence of swap lines with major central banks and membership in regional financing arrangements that could be tapped as a foreign-currency lender of last resort reduces the extent to which local monetary policy follows base-country monetary policy. Overall, our results cast doubt on the ability of exchange rate flexibility to enhance monetary independence, thereby on the empirical validity of the trilemma in recent times.