The Impact Of Exchange Rate Regimes On Monetary Independence

In 1999,Krugman drawed experience from the Asian Financial Crisis and proposed the Impossible Trinity theory based on the Mundell-Fleming model.This theory is considered to have a strong explanatory power,but recently some scholars have begun to come up with questions.After the Financial Crisis broke out in 2008,central banks around the world,led by the Federal Reserve,implemented the quantitative easing policies,which led to capital floods,credit booms and speculative asset bubbles.When QE was withdrawn in 2013,the fragile financial situation worsened,and emerging countries were the first to bear the brunt.The exchange rate,known as the macroeconomic stabilizer,seemed inadequate to prevent capital outflows and maintain monetary policy autonomy.The huge spillover effect of the Federal Reserve 's monetary policy is partly due to its control over global liquidity,and partly due to the common trend of asset prices,credit growing as well as risk aversion in the whole world,that is,the Global Financial Cycle.Some scholars believe that the exchange rate system will fail in the Global Financial Cycle.The resilience of the domestic economy depends more on the capability of volatile and potentially disruptive capital flows to enter and exit domestic financial markets.Therefore,the trilemma will be reduced to dilemma.In the world of financial globalization,it is important to study how to balance the exchange rate stability and financial openness,as well as the impact which exchange rate stability and Global Financial Cycle pose on the independence of monetary policy.Taking the floating exchange rate as an example,this thesis first demonstrates its effect on both enhancing and weakening the independence of monetary policy.The former is based on the theory of Non-covered Interest Rate Parity.Its core idea is that when capitals can flow freely,the expected forward exchange rate depends on the spreads of domestic and foreign interest rate.This theory uses a simple formula to link money and capital markets,as well as domestic and foreign markets.The latter effect is based on Mishkin(2001)'s discussion of the two channels through which the exchange rate affects the macroeconomy—namely current account channels and balance sheets channels.In the following econometric analysis,this thesis adopts the fixed-effect model and then performs regression analysis with selected variables.The results show that the impact of the exchange rate system on the independence of monetary policy is significant,which means the trilemma exists within the selected time period.Then this thesis released the fixed time effect and brings in the VIX index and its dummy variable--Stress,which both represent the Global Financial Cycle.The study find that in the years with an average annual VIX higher than 25.60,that is,2001,2002,2008,and 2009,the Global Financial Cycle significantly weakens the independence of monetary policy,which means a threshold exists.Finally,this article introduces the cross-term of the exchange rate system and Stress.However,its coefficient turns out to be insignificant,indicating that the Global Financial Cycle does not weaken the impact of the exchange rate system on the independence of monetary policy,and the two component of the cross-term works independently.