The widespread belief among economists that the components of Mundell's `Holy Trinity' fixed exchange rates, independent monetary policies and perfect capital mobility are mutually incompatible was illustrated most recently by the effective collapse of the ERM just a few years after the final barriers to capital mobility were removed. In Discussion Paper No. 929, Research Fellow Andrew Rose attempts to quantify the trade-offs between exchange rate stability, monetary divergence and capital mobility for a panel of monthly data for 22 countries during 1967-92, which cover widely varying exchange rate regimes, capital market regulations and macroeconomic policies.

Rose finds that monetary divergence and increased capital mobility are usually associated with increased exchange rate turbulence, but the relationships are statistically weak and there is surprisingly little evidence of a trade-off among the three components. These results may be explained, however, by the symmetrical treatment of long periods of tranquillity and shorter periods of crisis. Many accounts of the 1992-3 ERM crises have neglected the extended period of stable exchange rates, increased monetary divergence and high capital mobility that preceded the speculative attacks.

Rose also finds a highly significant positive link between the width of the official exchange rate band and conditional exchange rate volatility, so stated exchange rate policy has a significant effect on exchange rate volatility above and beyond the effects of actual macroeconomic policy. Despite the difficulties of measuring monetary independence and capital mobility, these results cast doubt on the effectiveness of recent proposals for wide (and loose) real exchange rate bands to reduce volatility (and misalignments). The proposed reintroduction of capital controls may do little to reduce exchange rate volatility, which the 1993 widening of the ERM bands may even increase. Divergence of monetary policy and the extent of capital mobility appear neither necessary nor sufficient for an exchange rate regime to collapse; macroeconomic convergence therefore need not deter exchange rate instability.

Exchange Rate Volatility, Monetary Policy, and Capital Mobility: Empirical Evidence on the Holy Trinity
Andrew K Rose

Discussion Paper No. 929, March 1994 (IM)