ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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The New Triad of Policy Concerns

Monetary Policy, Sovereign Debt and Financial Stability: The New Trilemma edited by Deepak Mohanty (New Delhi: Reserve Bank of India, Foundation Books, Cambridge University Press India), 2014, pp xiv + 370, Rs 995.

The recent global financial crisis has led economists and policymakers to revisit the macroeconomic triad of monetary policy, fiscal policy, and financial stability. The lead article in this collection by Duvvuri Subbarao, former governor of India’s central bank, describes this triad as the new trilemma, recalling the Mundell-Fleming trilemma of policymakers having to let go of at least one of the following three – independent monetary policy, fixed exchange rates, and an open capital account. Fiscal policy did not feature in the original trilemma possibly because it was articulated when fiscal dominance was no longer an issue in advanced economies. In sharp contradistinction, fiscal dominance continued to cast a long shadow on the independence of monetary policy in emerging markets, even as they struggled with the Mundell-Fleming trilemma. With advanced economies moving to a regime of free-floating reserve currencies, the trilemma remained relevant only to developing countries, especially following the surge in volatile cross-border capital flows.

Has the position changed since the global financial crisis? While fiscal dominance has abated considerably in emerging markets, the trilemma remains as relevant as ever, notwithstanding a recent influential paper that seeks to reduce this to a mere dilemma.1 In advanced economies, high levels of fiscal deficits and public debt have led to a return of fiscal dominance on the one hand, while dramatic quantitative easing (QE) has raised the spectre of a currency war of exchange rates among reserve-issuing currencies. Both these developments have led to a loss of monetary independence. Ironically, even as loose monetary policy is pilloried as one of the ultimate causes of the global financial crisis for inflating asset bubbles, monetary policy is even looser in the post-crisis period when measured by the metrics of the widely used Taylor Rule, raising the apparition of another financial crisis.

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