Monetary Policy, Exchange Rate and Capital Flow — From 'Equilateral Triangle' to 'Scalene Triangle'

The People’s Bank of China Working Paper Series, No. 2017/3

39 Pages Posted: 13 Apr 2017 Last revised: 10 Feb 2019

See all articles by Guofeng Sun

Guofeng Sun

Research Institute of People's Bank of China; Economics Department of Princeton University

Wenzhe Li

Tsinghua University, PBC School of Finance; The People's Bank of China (PBC)

Date Written: March 30, 2017

Abstract

The Chinese version of this paper can be found at: http://ssrn.com/abstract=2949313.

The traditional “Impossible Trinity” is an equilateral triangle. But since 2008, importance of capital flow has been greatly elevated, and equilateral triangle has transformed into scalene triangle. We first in the literature propose the “Scalene Impossible Trinity”, which is a more general analytical framework about “Impossible Trinity”. We also establish a theoretical model, and with the premise of “Scalene Impossible Trinity”, calculate the optimal level of macro-prudential management regarding cross-border capital flow and optimal level of international monetary policy coordination within different foreign exchange rate regimes. Our proof shows that even if foreign exchange rate could float freely, the central bank should conduct a certain level of macro-prudential management of cross-border capital flow. Based on this model and recent practices of The People’s Bank of China, we also present the New Macro-Financial Policy Framework (New MFPF), which is “Macro-prudential management plus Exchange rate flexibility plus International monetary policy coordination.” Only by adopting this three-pronged strategy, the central bank could attain macroeconomic equilibrium.

Keywords: Impossible Trinity, Capital Flow, Macro-prudential Management, Policy Framework

JEL Classification: E52, F38, F41

Suggested Citation

Sun, Guofeng and Li, Wenzhe, Monetary Policy, Exchange Rate and Capital Flow — From 'Equilateral Triangle' to 'Scalene Triangle' (March 30, 2017). The People’s Bank of China Working Paper Series, No. 2017/3, Available at SSRN: https://ssrn.com/abstract=2949307 or http://dx.doi.org/10.2139/ssrn.2949307

Guofeng Sun

Research Institute of People's Bank of China ( email )

No.32 Chengfang Street
Beijing, Beijing 100800
China

Economics Department of Princeton University ( email )

22 Chambers Street
Princeton, NJ 08544-0708
United States

Wenzhe Li (Contact Author)

Tsinghua University, PBC School of Finance ( email )

No. 43, Chengdu Road, Haidianqu
Beijing, 100083
China

The People's Bank of China (PBC) ( email )

No.32 Chengfang Street, Xichengqu
Beijing, 100800
China

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