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Impossible Trinity, Capital Flow Market and Financial Stability

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KYKLOS,Vol.62–November2009–No.4,611–618

ImpossibleTrinity,CapitalFlowMarketandFinancialStability

MoPak-HungÃ‘‘Moneyhasbecomeacommodityratherthanameansofexchange,tradingatavolumeofoverUS$1.9trilliondollarsperday.Thisenormousamountmovesaroundtheworldwithoutrestriction,seekingmaximumshort-termproﬁt.Whencurrencyspeculators‘‘bet’’againstacurrencyandrapidlywithdrawbillionsfromacountry,theywreckhavoconitseconomyandpeople’slives.’’/www.currencytax.orgS,dateaccessed:2008.

I.INTRODUCTION

AsobservedbyCalvo(2002),theworldﬁnancialmarketiswroughtwithsystemichazardsthatarelargelyindependenttotheindividualcountriesaﬀected.Systemicproblemrequiressystemicinstrument.BasedontheMun-dell-Flemingmodel,weinstituteacapitalﬂowmarketintoaneconomy.Aftertheadditionalmarketisintroduced,countriescanenjoythebeneﬁtsfromopeningtheirforeignexchangeandcapitalmarketsbutatthesametime,befreefromexchangeratevolatilityandﬁnancialcrisesaswellasretainfullautonomyinmonetaryandﬁscalpoliciesformaintaininginternalbalances.The‘globa-lizationhazard’isresolved.

TheMundell-Flemingmodelsuggeststhataneconomycannotsimulta-neouslymaintainexchangeratestability,freecapitalmovement,andanindependentmonetarypolicy.Thisprincipleisfrequentlycalledthe‘Impos-sibleTrinity’ortheTrilemma.Thebestpossibleoptiontoaneconomyischoosingtwooutofthethree.Itcanallowfreecapitalmovementandretainmonetaryautonomy,butatthecostofexchangeratevolatilityasthecaseinCanada;itcanﬁxitsexchangerateandretainmonetaryautonomy,butonlywheneﬀectivecontroloncapitalﬂowscanbemaintainedasthecaseinChina;aneconomycanﬁxitsexchangeratewithfreecapitalmovementattheexpenseofmonetaryautonomyasthecaseinHongKong.Themodelhasbecomethe

ÃSchoolofBusiness,HongKongBaptistUniversity.Email:phmo@hkbu.edu.hkThispaperwaspresentedintheFourthAnnualConferenceofAsia-PaciﬁcEconomicAssociation,Beijing2008andtheKoreaandtheWorldEconomy,VIII,2009,HongKong.Theauthorwantstothanktherelatedparticipantsfortheirusefulcomments.Inparticular,ProfessorsJ.AizenmanandK.Wongprovideusefulcommentsforimprovingthepaper.However,allerrorsarethesoleresponsibilityoftheauthor.

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OxfordOX42DQ,UKand350MainStreet,Malden,MA02148,USA

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workhorseforanalyzingfundamentalproblemsininternationalﬁnanceandthefoundationformakingrelatedpublicdecisions.

Inrecentdecades,thevalidityoftheImpossibleTrinityhasbeenrepeatedlyveriﬁed.Theforcesofglobalizationhavemadecapitalcontrolsamongcountriesincreasinglyporousduetotheenormousincreaseoftradeingoodsandservices.Somecountriesintentionallyopenuptheircapitalaccountinordertotapthepotentiallybeneﬁtsbroughttotheireconomies.Inmanycases,theyalsodesiretomaintainexchangeratestabilitybyadoptingaﬁxedexchangerateregime.Thephenomenoniscommonindevelopingandemergingeconomies.Whentheeconomiesaresmallandopenwithimmatureandthinﬁnancialsector,exchangeratestabilityisparticularlyvaluabletotheirinternationaltransactions.However,inthelong-run,thechoiceisincompa-tibleaspredictedintheMundell-Flemingmodel.Theeconomiesmakingsuchchoiceexperienceperiodicalboomsandbustsintheirassetandﬁnancialmarkets.TheyresultintheextensivelydocumentedﬁnancialandcurrencycrisesasintheLatinAmericanandAsiancountriesthatcausewidespreadpainsanddestructions.1Theexperienceshavemademanydevelopingecono-miesextremelycautiousinopeningtheircurrencyandassetmarketsthatbecomesaformidableobstacleforfurtherglobalintegrationandadvance-ments.Theglobalnatureofthephenomenonsuggeststhatthehazardissystemicandrequiresinstitutionalsolution.Achievingcompatibilitybetweenﬁnancial/economicstabilityandcapitalmobilitycanremovethedeadlocktowardsglobalintegrationthatwillbebeneﬁcialtobothcapitalabundantandcapitalscarceeconomies.

WeintroducetheextendedMundell-Flemingmodelthatincludesacapitalﬂowmarketinthenextsection.Sectionthreediscussesthepotentialeﬀectsofinstitutingthecapitalﬂowmarketandconcludes.

II.THEMODEL

TheIS-LMmodelcapturesthekeyinteractionsamongthemoneyandgoodsmarkets.RobertMundellandMarcusFlemingextendtheIS-LMmodelbyincorporatinginternationaltradeandcapitalﬂowfactorsintothemodel.Themajorconclusionsofthemodelarebasedoncomparativestaticanalysisoftheopen-economyIS-LMmodel,augmentedwitharelationbetweencapitalﬂowsandthedomesticinterestrate.(Mundell,1963,2002)Inthecaseofasmallopeneconomy,interestrateisﬁxedandbalanceofpaymentscanonlybeachievedby

1Thetransmissionprocessandobservationsaboutcapitalﬂows,assetprice,liquidityandﬁnancialvolatilityarediscussedindetailinAdriaandShin(2008).SomerepresentativethinkingsaboutrelatedissuesonﬁnancialliberalizationcanbereferredtoEichengreen,HausmannandPanizza(2002),TornellandWestermann(2005),amongmanyothers.

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IMPOSSIBLETRINITY,CAPITALFLOWMARKETANDFINANCIALSTABILITY

achangeinexchangeratethatisdrivenbytheconditionsinthetradeaswellasthecapitalﬂowsectors.However,theinterestrateand/ortheexchangeratethatisdesirableforinternalbalancesmightnotcoincidewithitstradeandcapitalﬂoweﬀectsandviceversa.Inordertoopenthecurrencyandassetmarketswhileatthesametimeshelteredfromﬁnancialcrises,weconstructacapitalﬂowmarketbyinstitutingapriceforcapitalﬂowandan‘assetdollarmechanism’asagatetoregulatethesizeofcapitalinﬂoworoutﬂowwithinaperiod.Similartothepriceineverymarket,thismarket-drivenpricewillregulatetheallocationofcapitalinﬂoworoutﬂowtothehighestvalueusersandautomaticallyequatetheamountofcapitalinﬂowandoutﬂow.AsillustratedinFigure1,whencapitalinﬂowislargerthanoutﬂowasatr1n,thegovernmentsetsaquotaonthesizeofcapitalinﬂowthatequalstotheamountofexpecteduncontrolledoutﬂowQi.Theinﬂowquotaisauctionedtoqualiﬁedinstitutionstoserveasthemarket-makersandwholesalersofthequotathatiscalledassetdollar.Themarketpriceofthequotaiscalledassetpremiumwhichisdenotedby‘a’.‘a’canbepositiveornegative.Negative‘a’representschargingapriceonthecapitaloutﬂowwhentheoutﬂowislargerthanthe

Figure1

CapitalFlowMarketandAssetPremium:ExcessInﬂowandoutﬂow

rn = r – rfAUAI + aiAIauExcess AIrn1ai0rn0QuAI , AUQiExcess AUAU –auAI/AU: amount of capital inflow/outflow; Qu / Qi: outflow/inflow quota;au/ai: outflow/inflow premium; r/rf: return rate of domestic/foreign assets r2009BlackwellPublishingLtd.

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inﬂowsuchasthesituationatr0ninFigure1.Theintroductionoftheassetpremiumthatservesasthepriceenteringtheinternationalassettradingmarketcanachieveabalancedcapitalaccount.2Underaﬂexibleexchangerateregime,exchangerateﬂuctuationismostlydrivenbyinternationalspeculativeﬂowsthattendtobeveryvolatileanddestabilizingtotheassetandﬁnancialmarkets.Whencapitalﬂowsarestabilizedundertheassetdollarsystem,aﬂexibleexchangerateregimecanbeadoptedthatwillautomaticallybalancethetradeaccount.Afterthecapitalﬂowsareregulatedbyitsownprice,exchangeratewillbepurelydrivenbytradingtransactionsthatnormallyevolvesteadilyovertime.Evenunderaﬂexibleexchangerateregime,thevolatilityofexchangerateandtheassociatedcostsandriskstointernationaltransactionswillbesubstantiallyreduced.Whenthebalancesofthecapitalandtradeaccountsareregulatedbytheirrespectiveprices,acountryisfreetoadoptmonetaryandﬁscalpoliciestoattainitsinternalbalance.

Wehavefourmarketsintheeconomyunderthesystem:thedomesticmoneyandgoodsmarkets,theinternationaltradeandtheinternationalcapitalﬂowmarkets.ThemodelfollowsthetraditionoftheIS-LMandlatertheMundell-Flemingconstructionstoillustratetheinteractionsamongthemarkets,thefactorsdrivingthekeymacro-variablesandthetransmissionmechanismsofthemonetaryandﬁscalpoliciesforregulatingthemarkets.i.TheBalanceofCurrentAccount

NetExportðNXÞ¼exportÀimport¼NX0Àe1eÀe2Yþe3Yf;whereNX0istheautonomousnetexport;e($f/$d)istherelativepriceofdomesticdollar($d)intermsofforeigndollar($f);thehigherthee,thehigherthepriceof$d;YandYfarethedomesticandforeignrealincomerespectively;e1,e2,ande3areconstantswithvaluesgreaterthanzero.Imposingabalancedcurrentaccount,NX50,wehave:

e1eþe2Y¼NX0þe3Yf¼NXn

ðE1Þ

Onemaynotethatimposingaﬂoatingassetpremiumequalstothemarketprice‘a’hasthesameeﬀectofthequotaauctionsystem.However,settingthepremiumequaltothemarket-clearing‘a’whichconstantlyﬂuctuateswiththeinformationaboutdomesticandinternationalenvironmentsisalmostimpossiblewithoutthequotamarket.Thequotaauctionsystemcanbeinterpretedasatoolforgeneratinginformationonthemarketvalueofthequotainthecapitalﬂowmarket.AsillustratedinFigure1,whenthereisanexcessdemandforcapitalinﬂowgiventhedesireddomesticinterestrateforinternalbalance,weraisetheopportunitycostofcapitalinﬂowbyimposinganinﬂowpremium,ai;whenthereisanexcessdemandforcapitaloutﬂow,wereducethebeneﬁtofcapitaloutﬂowbyimposinganoutﬂowpremiumau.TheAIandAUcurvesandhencetheassetpremiumconstantlyadjustaccordingtothemarketconditions.

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ii.TheBalanceofCapitalAccount

NetCapitalInflowðNAÞ¼inflowÀoutflow¼NA0ÀZ1aþZ2rÀfe;whereNA0istheexogenousnetcapitalinﬂowthatcanbeaﬀectedbyforeigninterestrate,expectedchangeinexchangerateandpolitical,socio-economicfactors;risthedomesticinterestrate;‘a’isthemarket-drivenpriceofcapitalinﬂoworoutﬂowasabove-mentioned,with2NoaoN;theparametersaregreaterthanzero.3Thelowerthepriceofcapitalinﬂow‘a’,thehigherwillbethenetcapitalinﬂow;thehigherthepriceofdomesticcurrency‘e’willcausehigher/lowercapitaloutﬂow/inﬂowandthereforelowersthenetcapitalinﬂow;higherdomesticinterestattracts/reducescapitalinﬂow/outﬂow.WithNA50,wehave:

ÀZ2rþZ1aþfe¼NA0

ðE2Þ

InE2,thepriceofcapitalinﬂow/outﬂow,‘a’,adjuststomaintainabalancedcapitalaccountwhileeandrrespectivelyservetobalancethecurrentaccountandtoattaindesirableinternalbalance.4iii.TheMoneyMarketEquilibrium

Demandformoney5Md52b1r1b2Y,

withb1;b2>0:

Moneysupply5Ms5MS0,isexogenousandcontrolledbygovernment.Inequilibrium,Ms5Mdimplies:

Àb1rþb2Y¼MS0:

ðE3Þ

iv.TheGoodsMarketEquilibrium

Consumptionfunction:C5C01rY,0oro1isthemarginalpropensitytoconsume.

3Havingextremevaluesof‘a’ishighlyunlikelywhenthemarket-drivencapitalinﬂoworoutﬂowpremiumisexpectedbytheagents.Incontrarytothesituationwhenthepriceofcapitalﬂowisabsent,internationalassettraderswillsmooththeirinﬂoworoutﬂowtoacountryinordertopaylowerpremiumsfortheirtransactions.Moreever,thesystemraisesthecostsoffrequentassettrading.Speculativecapitalﬂowsarereducedwhilelong-terminvestmentsareencouraged.Pleaserefertofootnote2also.4Imposingabalancedcapitalaccountisforsimplicity.Sometimesacountrymightwanttohavecapitalaccountsurplusordeﬁcit.ItisequivalenttoimposeNAequaltoaconstantinsteadofzeroandsolveforthesolutionsinthesystem.Moreover,underthesystem,governmentsarefreetointroducedesirableindustrialpolicysuchastreatingforeigndirectinvestmentwithmorefavorabletermsthanthosepureassettrading.

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Investmentfunction:I¼IdþIf¼I0Àd1rÀd2a;Netexport:NX¼NX0Àe1eÀe2Yþe3Yf;Aggregateexpenditure:AE¼CþIþGþNX;

whereAEistheaggregateexpenditureondomesticgoods,C,IandGareconsumption,investmentandgovernmentpurchase;IdandIfarethedomesticandforeigninvestmentrespectively;theparametersaregreaterthanzero.

Inequilibrium,Y5AE,wehave:

enYþd1rþd2aþe1e¼AE0;withen¼ð1Àrþe2Þ

whereAE05C01I01G1NX01e3Yf.SolvingE1toE4,wehave:

YÃ¼

Àb1d2e1NA0þe1ðd1Z1þd2Z2ÞMS0þb1ðfd2Àe1Z1ÞNXnþe1b1Z1AE0

jAj

ðE4Þ

ðE5Þ

rÃ¼

Àb2d2e1NA0À½e1Z1ð1ÀrÞþfd2e2󰀄MS0þb2ðfd2Àe1Z1ÞNXnþb2e1Z1AE0

jAjðE6Þ

eÃ¼

b1d2e2NA0Àðd1e2Z1þd2e2Z2ÞMS0þðb2d1Z1þb2d2Z2þb1Z1enÞNXnÀb1e2Z1AE0

jAj

ðE7Þ

½b2d1e1þb1e1ðenÀe2Þ󰀄NA0þ½d1fe2þe1Z2ðÀ1þrÞ󰀄MS0Àðb2d1fþb2e1Z2þb1fenÞNXnþðb1fe2þb2e1Z2ÞAE0

aÃ¼

jAj

ðE8Þ

where,jAj¼b1fd2e2þb2d1e1Z1þb1e1Z1ðenÀe2Þþb2d2e1Z2>0:

Thesolutionset(YÃ,rÃ,eÃ,aÃ)iscompatiblewiththeequilibriumssetinthemodel.Similartotheroleofinterestrateinequatingthemoneydemandtothemoneysupplythatiscontrolledbytheauthority,theequilibriumassetpremiumthatisdrivenbythedomesticandinternationalconditionsservestoequatethecapitalinﬂowandoutﬂowforpreventingthepotentially

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disruptivecapitalﬂowsandtheassociatedﬁnancialandeconomicinstabil-ities.5III.CONCLUSION

Theinnovationinthispaperistheintroductionofamechanismandtherelatedmarketpriceintothecapitalﬂowmarket.Inthissystem,themarket-drivenassetpremium‘a’adjustsautomaticallytoequilibratethecapitalﬂowsinresponsetothechangesinrelatedmarketconditions.Thefullyﬂexibleexchangerateadjuststoclearthetrademarketandmonetarypolicycanbeshelteredfrominternationalcapitalﬂowsandbeabletoattaindesirableinternalstabilitythroughtheinterestratechannel.Now,eachkeymarketintheeconomyhasavariablethatcanexertdirectinﬂuenceonthedesirablesituation.Aneconomycanenjoythebeneﬁtsfromopeningtheinternationalcapitalﬂows,currencyandassetmarketswhileatthesametimemaintaininginternaleconomicstability.Althoughthedetailsonimplementationmayneedtobefurtherinvestigated,thetheoreticalpossibilityandtheadjustmentmechanismareprovidedinourmodel.6ThisextendedMundell-Flemingmodelsuggetsthatafterinstitutingthecapitalﬂowmarket,aneconomy,largeorsmall,developingordeveloped,willbeableto:

i.haveafullyﬂexibleexchangerateregimeandthebalanceoftradeisrapidlyandautomaticallyattained.Theexchangeratetendstobeverystableasitispredominantlydrivenbytradeconditionsonly.

ii.enjoythebeneﬁtsofcapitalmobilityaswellasastableandbalancedcapitalaccountwhileatthesametime,havingindependentmonetaryandﬁscalpoliciesforattaininginternalgoals.

iii.preventerraticinternationalcapitalﬂowsthatdisturbthedomesticcredit

andassetmarkets.Periodicalboomsandbustswithﬁnancialandcurrencycriseswillbeeliminated.

FormaintaininginternalbalancesuchthatYequalstothenon-inﬂationaryoutputlevel,YN,agovernmentcanpickacombinationofﬁscalandmonetarypolicy,thatis,MS0andAE0,andthereforerÃwhileleavingthetradeandcapitalﬂowmarketsadjustingautomaticallytotheirequilibriumswiththeirrespectiveprices.6Inimplementation,thesystemisequivalenttoimposingaﬂoatingtransactiontaxequalto‘a’onassettrading.Whencapitalinﬂowislargerthantheoutﬂow,buyersofassetshavetopayapremiumequaltothemarketpriceofthecapitalinﬂowquota.Thiswilllowerthereturnofassetsinparwiththeinternationalmarket.Whenoutﬂowislargerthaninﬂow,assetsellershavetopaya‘premium’equalstothemarketpriceofthecapitaloutﬂowquotathatwillreducethebeneﬁtsoftheoutﬂow.Thevalueof‘a’ismarket-drivenandautomaticallygeneratedbythequotatradingmarket.Themanagementcostislowandtheoutcomeisprecise.Eﬀectively,theexchangerate,domesticassetpriceandcreditﬂuctuationsdrivenbyinternationalcapitalﬂowarereplacedbytheﬂuctuationintheassetpremium,thepriceofparticipatingininternationalcapitalﬂowandassettrading.

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Atpresent,thereareenoughevidencesthatalldevelopingandemergingeconomiesaresusceptibletothedamagescausedbythemassiveanderraticinternationalspeculativecapitalﬂows.Theassetdollarsystemeliminatestherisksofopeningthecapitalﬂowandcurrencymarketsthataretwoformidableobstaclestowardglobaleconomicintegration.Inducedbythedirectﬁscalrevenuegeneratedfromthehigherassetpremiumandactiveassettrading,governmentswillimprovethedomesticinvestmentenvironmentsandtheeﬃciencyoftheassetmarkets.Moreover,theadditionalﬁscalrevenuecanbeusedtoreplacesomecounter-productivetaxesthatcanfurtherfacilitateimprovementsineconomicwell-being.Underthesystem,globaleconomicintegrationandsocio-economicadvancementswillsurgewhenallgovernmentsattempttocapturethepotentialbeneﬁtsofopeninguptheircurrency,capitalﬂowandassetmarkets.

REFERENCES

Adria,T.andH.S.Shin(2008).Liquidity,MonetaryPolicy,andFinancialCycles,CurrentIssuesin

EconomicsandFinance.14(1).

Calvo,G.A.(2002).GlobalizationHazardandDelayedReforminEmergingMarkets,Economı´a.

2(2):1–29.

Eichengreen,B.,R.HausmannandU.Panizza(2002).‘‘OriginalSin:ThePain,theMystery,andthe

RoadtoRedemption,’’Paperpreparedfortheconference‘‘CurrencyandMaturityMatchmak-ing:RedeemingDebtfromOriginalSin,’’Inter-AmericanDevelopmentBank,Washington,D.C.,21–22November2002.

Mundell,R.A.(2002).NotesontheDevelopmentoftheInternationalMacroeconomicModel,in

TheOpenEconomyMacromodel:Past,Present,andFuture.ed.byArieArnonandWarrenYoung,Boston:KluwerAcademicPublishers:1–16.

Mundell,R.A.(1963).CapitalMobilityandStabilizationPolicyunderFixedandFlexibleExchange

Rates,CanadianJournalofEconomicsandPoliticalScience.29:475–85.

Tornell,A.andF.Westermann(2005).Boom-BustCyclesandFinancialLiberalization.Cambridge,

MA:MITPress.

SUMMARY

AsobservedbyCalvo(2002),theworldﬁnancialmarketiswroughtwithsystemichazardsthatarelargelyindependenttotheindividualcountriesaﬀected.Systemicproblemrequiressystemicinstrument.BasedontheMundell-Flemingmodel,weinstituteacapitalﬂowmarketintoaneconomy.Aftertheadditionalmarketisintroduced,countriescanenjoythebeneﬁtsfromopeningtheirforeignexchangeandcapitalmarketsbutatthesametime,befreefromexchangeratevolatilityandﬁnancialcrisesaswellasretainfullautonomyinmonetaryandﬁscalpoliciesformaintaininginternalbalances.The‘globalizationhazard’isresolved.

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