Edited by Marc Uzan
Chapter 10: Exchange rates and capital controls in developing countries
10. Exchange rates and capital controls in developing countries* Vijay Joshi What are the implications of ﬁnancial globalization for exchange rate regimes in developing countries? It is to this question that this chapter is addressed. THE IMPOSSIBLE TRINITY AND THE BIPOLAR VIEW I begin with the well-known trilemma, sometimes referred to as the ‘Impossible Trinity’, to which policymakers in any open economy must respond. A crucial insight of the Impossible Trinity is that the choice of exchange rate regime cannot be considered separately from the choice of policy stance towards capital ﬂows. The standard formulation of the Impossible Trinity says that it is impossible to achieve the following three desirable goals simultaneously: exchange rate stability, capital market integration and monetary autonomy. Any pair of goals is achievable by choosing a suitable payments regime but requires abandoning the third. Speciﬁcally: 1. Exchange stability and capital market integration can be combined by adopting a ﬁxed exchange rate but requires giving up monetary autonomy. The authorities lose the power to vary the home interest rate independently of the foreign interest rate. Monetary autonomy and capital market integration can be combined by ﬂoating the exchange rate but requires giving up exchange stability. The authorities have the freedom to choose the home interest rate but they must in consequence accept any exchange rate that the market dictates. Exchange stability can be combined with monetary autonomy but requires giving up capital market integration. In the presence of capital controls, the interest rate–exchange rate link...
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