The political economy of the impossible trinity

This paper reconsiders the policy trilemma in an open economy by incorporating political economy concerns. In this regard, the behavior of policymakers and resulting economic cycles might be affected by reelection considerations (opportunistic cycle) or by the ideology of a decision maker (partisan cycle). We argue that the impact of government ideology on monetary policy, exchange rate policy, and capital account policy decisions should be analyzed in the more general context of restrictions imposed by the impossible trinity instead of the usual single-dimensional constraints. In order to consider the trilemma problem properly, we simultaneously estimate equations determining monetary, exchange rate, and capital flow policy choices in a three-stage least squares (3SLS) approach. In addition, we run a K-means cluster analysis based on the three measures provided by Aizenman et al. (2010) to identify country groups that represent similar trilemma policy regimes. Considering these restrictions by a de facto measurement of the respective policy decisions and a sample of 124 countries from 1980 to 2014, we show that government ideology only has a direct impact on one component of the trilemma, namely exchange rate stability. Our empirical results are based on a data-driven and cluster-based distinction between open / rich and closed / poor countries and, as a robustness check, also on a split of OECD vs. non OECD countries. Overall, we find that the analysis of ideology effects on policy choices in open economies should be carried out in the context of a joint determination of the impossible trinity variables. We find ideology effects to be most important in the context of exchange rate policy.