ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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The Impossible Trinity and the Taylor Rule

A Monetary Policy Rule for Emerging Market Economies

The recent global debate on monetary policy has centred on whether policy should target financial stability in addition to the domestic business cycle. With relatively tightly regulated fi nancial markets, where concerns presently are more developmental than regulatory, the counterpart debate in emerging market economies centres on reconciling two widely held economic policy formulations, namely, the Mundell-Fleming "Impossible Trinity" and the "Taylor Rule". This article argues that EMEs can get around the trilemma by adopting a separate0 instrument as part of a consistent policy framework to target the external financial cycle. This would free up their interest rate policies to target the domestic business cycle, without the need to deviate from the Taylor Rule from time to time to target external fi nancial stability.

The currency crisis sweeping emerging market economies (EMEs), which has compelled Brazil, Turkey and Indonesia to tighten policy rates amidst collapsing growth, merits revisiting the application of two widely held economic policy formulations, namely the Mundell-Fleming “Impossible Trinity” and the “Taylor Rule” of monetary policy.

According to the impossible trinity, a country can have only two of the following three: a fixed exchange rate, monetary independence and free capital flows. A free monetary policy means that it is free to respond to the domestic business cycle.

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