Discussion Paper

No. 2014-13 | March 28, 2014
The Possible Trinity: Optimal Interest Rate, Exchange Rate, and Taxes on Capital Flows in a DSGE Model for a Small Open Economy


A traditional way of thinking about the exchange rate regime and capital account openness has been framed in terms of the 'impossible trinity' or 'trilemma', according to which policymakers can only have two of three possible outcomes: open capital markets, monetary independence and pegged exchange rates. The present paper is a natural extension of Escude (A DSGE Model for a SOE with Systematic Interest and Foreign Exchange Policies in Which Policymakers Exploit the Risk Premium for Stabilization Purposes, 2013), which focuses on interest rate and exchange rate policies, since it introduces the third vertex of the 'trinity' in the form of taxes on private foreign debt. These affect the risk-adjusted uncovered interest parity equation and hence influence the SOE's international financial flows. A useful way to illustrate the range of policy alternatives is to associate them with the faces of an isosceles triangle. Each of three possible government intervention policies taken individually (in the domestic currency bond market, in the foreign currency market, and in the foreign currency bonds market) corresponds to one of the vertices of the triangle, each of the three possible pairs of intervention policies corresponds to one of the three edges of the triangle, and the three simultaneous intervention policies taken jointly correspond to the triangle's interior. This paper shows that this interior, or 'possible trinity' is quite generally not only possible but optimal, since the central bank obtains a lower loss when it implements a policy with all three interventions.

JEL Classification:

E58, F38, O24


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Cite As

Guillermo J. Escudé (2014). The Possible Trinity: Optimal Interest Rate, Exchange Rate, and Taxes on Capital Flows in a DSGE Model for a Small Open Economy. Economics Discussion Papers, No 2014-13, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2014-13

Comments and Questions

Anonymous - Referee report 1
May 16, 2014 - 09:17

I highly appreciated reading the paper entitled „The Possible Trinity: Optimal interest rate, exchange rate, and taxes on capital flows in a DSGE model for a Small Open Economy“. The author builds a DSGE model to analyze the impact of capital controls on macroeconomic stability modeled as a tax on ...[more]

... either foreign liability of households or a tax/subsidy scheme for flows of liabilities. He finds that, in general, the tax reduces the loss of institutions following their policy functions.

The author puts a lot of effort in building a DSGE model capturing a complex setting of assets and describes the intuition behind those equations very well. He, furthermore, shows the reason why losses in the different scenarios differ. As this may be the most crucial part of the model, it might be the reason why the author discusses the impulse response functions very shortly. I would suggest to add some more explanations on the differences in IRFs in the different scenarios even if the paper is already pretty long. Additionally, the author might think about including some insights into how the small economy assumption affects the results. Is the kind of tax imposed always beneficial in terms of a lower loss?

Guillermo J. Escudé - Reply to referee report 1
May 30, 2014 - 09:58

see attached file

Anonymous - Referee report 2
May 19, 2014 - 09:38

see attached file

Guillermo J. Escudé - Reply to referee report 2
May 30, 2014 - 09:59

see attached file