Department of Economics, UCSC

Using the “trilemma indexes” developed by Aizenman et al. (2010) that measure the extent ofachievement in each of the three policy goals in the trilemma—monetary independence, exchange ratestability, and financial openness—we examine how policy configurations affect macroeconomicperformances, with focus on the Asian economies. We find that the three policy choices matter for outputvolatility and the medium-term level of inflation. Greater monetary independence is associated with loweroutput volatility while greater exchange rate stability implies greater output volatility, which can bemitigated if a country holds international reserves (IR) at a level higher than a threshold (about 20% ofGDP). Greater monetary autonomy is associated with a higher level of inflation while greater exchangerate stability and greater financial openness could lower the inflation rate. We find that trilemma policyconfigurations affect output volatility through the investment or trade channel depending on the opennessof the economies. Our results indicate that policy makers in a more open economy would prefer pursuinggreater exchange rate stability while holding a massive amount of IR. Asian emerging market economiesare found to be equipped with macroeconomic policy configurations that help the economies to dampenthe volatility of the real exchange rate. These economies’ sizeable amount of IR holding appears toenhance the stabilizing effect of the trilemma policy choices, and this may help explain the recentphenomenal buildup of IR in the region.