An investigation of monetary autonomy under corner solution and middle ground: A panel data analysis

Abstract

The objective of this study is to examine the existence of monetary autonomy within the framework of the macroeconomic trilemma hypothesis. We estimate panel data models with fixed effects, random effects, and fixed effects with cross-sectional dependence to assess monetary autonomy in 36 countries from January 1991 to December 2023. The dependent variable captures changes in policy interest rates in these peripheral countries, while the independent variables include changes in the U.S. policy interest rate, nominal exchange rate regimes (flexible vs fixed or float, soft peg, and peg), capital mobility regimes (capital controls vs free capital mobility or closed, mid-open, and open), foreign exchange reserves relative to nominal GDP, and indicators for currency/financial crises and Covid-19, among others. Using monthly data from various sources, we find no evidence of monetary autonomy under a fixed exchange rate with free capital mobility in both the “corner solution” and “middle ground” models, aligning with the macroeconomic trilemma hypothesis. However, we do find evidence of monetary autonomy in the middle ground case (soft peg with mid-open capital market) and that further evidence that foreign exchange reserves can mitigate the trilemma hypothesis.