From Trilemma to Dilemma: Monetary Policy Effectiveness after the Bretton Woods World

Abstract

Many argue that the concept of the trilemma, referring that out of independent monetary policy, free capital movement and fixed exchange rate regime only two can exist at the same time, is a potent tool to explore the effectiveness of monetary policy during the Bretton Woods (BW) regime and afterward. However, under this regime, besides capital controls, regulated domestic financial markets and diversity in central bank instruments contributed to the existence of the independent monetary policy. After the collapse of the BW system, capital controls were lifted, domestic financial markets were deregulated, remaining regulations were not implemented properly, and short-term interest rates became the sole instrument of central banks. The size of financial flows and financial markets has reached unprecedented levels. The effectiveness (either short- or long-term) of a central bank mainly depends on the institutional framework in which the central bank operates. Since there have been very dramatic changes in the intuitional structure enabling domestic and international financial markets to be much more decisive in determining asset prices and credit expansion, the ability of central banks in both developed and developing countries has weakened although this is much more apparent in developing countries. This process can be considered a gradual transition from trilemma to dilemma implying that under current conditions exchange rate regimes become relatively irrelevant for the effectiveness of central banks especially in developing countries. The unorthodox policies implemented after the global financial crisis in both advanced and developing countries can be considered an incomplete realization of the dilemma by central banks.