Author’s Accepted Manuscript

The Political Economy of the Impossible Trinity

Joscha Beckmann, Esther Ademmer, Ansgar Belke,

Rainer Schweickert

www.elsevier.com

PII: S0176-2680(16)30251-8
DOI: http://dx.doi.org/10.1016/j.ejpoleco.2016.10.010
Reference: POLECO1607
To appear in: European Journal of Political Economy
Received date: 3 November 2015
Revised date: 16 October 2016
Accepted date: 19 October 2016
Cite this article as: Joscha Beckmann, Esther Ademmer, Ansgar Belke and
Rainer Schweickert, The Political Economy of the Impossible Trinity, European
Journal of Political Economy, http://dx.doi.org/10.1016/j.ejpoleco.2016.10.010
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 The Political Economy of the Impossible Trinity¶
Joscha Beckmannb*, Esther Ademmera, Ansgar Belkec, Rainer Schweickerta

a
Kiel Institute for the World Economy.

b
University of Bochum and Kiel Institute for the World Economy.

c
University of Duisburg-Essen and Kiel Institute for the World Economy.

*
corresponding author:

Abstract

This paper reconsiders the policy trilemma in an open economy by incorporating political

economy concerns. We argue that the impact of government ideology on monetary

independence, exchange rate stability, and capital flow restrictions should be analyzed in the

broader context of restrictions imposed by the impossible trinity instead of the usual single-

dimensional constraints. Employing a de facto measurement of these restrictions for a sample

of 111 countries from 1980 to 2010, we show that the impact of government ideology on a

country’s position in this trilemma is highly context dependent: We find that the impact of

partisan preferences on exchange rate stability and monetary independence varies between

developed and developing countries. We also show that the impact of government ideology

on these two trilemma components is contingent on the stance of the respective economy’s

business cycle. Left-leaning governments seem to favor exchange rate stability over monetary

independence in case of a negative output gap; suggesting a reversal of their commonly

assumed partisan preferences in economically tight times.

JEL Classifications:

F6, H8

¶
We would like to thank Gerald Fugger and Jennifer Rogmann their valuable research assistance.

0
Keywords:

Political Economy, Exchange Rates, Impossible Trinity

1. Introduction

The question of whether government ideology matters for various macroeconomic policies in

an open economy has attracted a great deal of interest among researchers (see, for instance,

Ellis and Thoma, 1996; Oatley, 1999). Next to reelection considerations (opportunistic

cycles), partisan preferences of policymakers might shape the conduct of macroeconomic

policies, resulting in so called partisan political business cycles.

Previous studies have, for instance, analyzed the impact of ideology on monetary and

exchange rate policy. One hypothesis is that left-wing governments have a higher preference

for inflation and flexible exchange rates than right-wing governments (Alesina, Roubini and

Cohen, 1997; Drazen 2000). Left-wing governments might aim at exploiting a short run

Phillips curve trade off when conducting monetary policy, which eventually results in higher

inflation (Barro and Gordon, 1983, Kydland and Prescott, 1977). In a similar fashion, it has

been argued that left-wing governments increase the likelihood of a flexible exchange rate

regime in order to bolster exports through depreciations (Chang and Lee, 2013).

In order to investigate monetary policy effects, early studies in the 1980s and 1990s used

money supply growth, inflation and - in a few cases - also official interest rates as “policy

instruments” to test whether ideology indeed matters for conducting monetary policy.1

Recognizing the importance of the monetary transmission mechanism, Belke and Potrafke

1
Belke and Potrafke (2012) summarize three possibilities available to governments to affect monetary policy:
nomination of the council members (Galbraith et al., 2007; Lohmann, 1998; Vaubel, 1993, 1997a, 1997b; Berger
und Woitek, 1997), signalling (Havrilesky, 1988, 1991; Sieg, 1997), and bashing and coercion (Lohmann, 1998;
Waller, 1991).

1
(2012) also focus on the time pattern of interest rates according to the Taylor Rule and find a

significant impact of ideology on monetary policy. This result seems remarkable since a

strong prior emerged in the profession that the partisan cycle must be dead in times of

inflation targeting - the monetary policy dogma prevailing in the paper’s sample period

preceding the financial crisis.

Whether partisan preferences can translate into macroeconomic policies in the first place

depends on the various economic, institutional and political contexts a policymaker operates

in (cf. Steinberg and Walter, 2013). A key suggestion for eliminating partisan or opportunistic

inflation biases, for example, has been to increase the degree of central bank independence as

a formal constraint to government interference (De Haan, Masciandaro and Quintyn, 2008).

Some institutional choices, however, also affect the availability of other policy instruments.

One example is a country that joins a monetary union and effectively gives up monetary

independence to achieve fixed exchange rates.

Despite analyzing several samples and countries, an important shortcoming of many previous

studies is that they neglect such a trilemma problem in an open economy, in which a

government faces several simultaneous policy choices. According to the impossible trinity

hypothesis, a fixed exchange rate regime, free capital flows, and monetary independence

cannot be achieved simultaneously. Only two of those aims can be realized at the same point

in time (Fleming, 1962; Mundell, 1963). The fact that some emerging economies still rely on

fixed exchange rates and restricted capital flows to allow for a certain degree of monetary

independence illustrates the importance of such a distinction (Fratzscher, 2012). Analyses of

monetary policy independence, however, often neglect the influence of exchange rate

fluctuations and the freedom of capital account flows (see, for instance, Obstfeld, Shambough

and Taylor, 2004). In the same vein, papers that analyze the political economy of exchange

rate regimes often neglect de facto degrees of monetary independence (see, e.g., Berdiev et al.

2
2012; Setzer, 2006) or capital flow restrictions (see Willett, 2004). Unlike central bank

independence that captures the formal independence of central banks from their respective

governments, de facto monetary independence means independence from interest rates of

other countries. Modelling macroeconomic policy choices with respect to only one of the

trilemma variables runs the risk of producing biased results due to misspecification.

Against this background, this paper asks how partisan preferences affect the positioning of a

country in this trilemma and analyzes the impact of ideology on the degree of monetary

independence and exchange rate stability as well as on capital flow restrictions in the context

of these trilemma restrictions. Importantly, it works in a framework, in which all three

trilemma dimensions are endogenous. In addition, while previous research usually takes into

account some kind of relationship between exchange rates and monetary policy, for example,

by considering the exchange rate regime when analyzing monetary policy, an explicit analysis

of the drivers of a country’s position with regard to the de facto trilemma is still missing. The

few studies that consider trilemma restrictions rely on formal classifications of de jure

exchange rate regimes, central bank independence, or capital flow restrictions (Berdiev et al.,

2013); which may not necessarily match the de facto restrictions that a policymaker faces

when making her interdependent choices. This is due to the fact that a country’s formal

central bank independence, for instance, does not necessarily imply its de facto monetary

independence: a formally autonomous central bank, for example, is still subject to

international constraints when setting interest rates depending on the degree of exchange rate

stability and flexibility in place.

As opposed to de jure, categorical measures, continuous measures that rely on dyadic

relationships between countries are able to capture these more fine-grained de facto

constraints. Against this background, we rely on the Aizenman et al. (2010, 2013) trilemma

index which mirrors the effective independence of monetary and exchange rate policy and the

3
freedom of capital flows. Their measure for exchange rate and monetary independence is

based on standard deviations from and correlations with an anchor currency or interest rate.

Applying a de-facto rather than a de-jure classification has the advantage that estimated

coefficients can thus also capture the partisan effect on de-facto monetary independence or

exchange rate stability, while effects on domestic interest rates or a de-jure exchange rate

classification do not necessarily allow for such a conclusion.

Apart from these trilemma constraints, we also analyze how business cycle dynamics affect

the way in which partisan preferences translate into different degrees of monetary

independence, exchange rate stability, and capital flow restrictions and thereby add to an

increasingly rich literature on contingent partisan effects.

In order to consider the trilemma problem properly, we simultaneously estimate equations

determining the degree of monetary independence, exchange rate stability, and capital flow

restrictions 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. Levy-Yeyati and Sturzenegger

(2005) adopt a related approach in the context of exchange rate regime classification. This

approach allows us to study whether the impact of partisan preferences on specific trilemma

positions systematically varies across countries that lean towards a certain trilemma regime.

As a robustness check and comparison to our classification, we estimate sample splits along a

formal distinction of OECD and non-OECD countries. We also analyze sub-periods and

consider fixed effect estimates as further robustness checks.

The remainder of the paper proceeds as follows. Section 2 provides a literature review.

Section 3 describes the data, the empirical model, and the econometric methodology. Section

4 summarizes the empirical findings and section 5 concludes.

4
2. Literature review

Partisan business cycles are usually distinguished from opportunistic cycles. Opportunistic

business cycles are defined as instances in which governments switch to more expansionary

monetary or fiscal policies before elections in order to increase their chances of re-election

(Nordhaus, 1975; Rogoff and Sibert, 1988; Rogoff, 1990). Partisan business cycles are instead

based on the idea that the partisan preference or the ideology of an incumbent government

impacts macro-economic policy decisions.

The underlying theoretical setting for analyzing these factors relies on a social loss function

which is minimized by the government and takes the following form:

(  )! & )!

(%  %
 = + #∗ +'*,- " + . (1)
" "

where  denotes losses, / unemployment, 0 inflation, while 01 and / refer to target values.

'*,- captures the volatility of the exchange rate. Depending on the character of the analysis,

loss terms for financial stability can be included in a similar fashion.

Uncertainty is captured by a stochastic shock . . The variance of such a shock is likely to

affect the losses that are incurred by governments: a larger variance in shocks may attach

greater benefits to flexible exchange rates; less variance may render exchange rate stability

more attractive, for instance.

Although such functional forms have been introduced in the context of monetary policy and

the inflation-unemployment trade-off, second-generation models of currency crises rely on the

5
same idea since they assume that governments continually evaluate the pros and cons of

maintaining a fixed exchange rate based on minimizing a social loss function (Rangvid, 2001;

Pilbeam, 2013). As outlined by Kydland and Prescott (1977) as well as Barro and Gordon

(1983), time inconsistency can arise in such circumstances. A policy chosen at time t for the

time t+s, is time-inconsistent if it is not equal to the actual policy chosen for the same period

t+s at that period. Policymakers might have an incentive to increase production (lower

unemployment) through unexpected inflation or depreciations of the domestic currency. The

strength of this incentive is likely to be shaped by partisan preferences of governments

reflected by the parameters of the above discussed loss function. As Hibbs (1977) and Alesina

(1987) argue in their early work, leftist governments are more likely to favour higher inflation

and lower unemployment; as opposed to rightist parties who cater for an electorate of capital

owners and consequently favour low inflation over low unemployment.

Whether these partisan preferences can translate into different degrees of monetary

independence, exchange rate stability or capital flow restrictions, however, is contingent on

various economic and political factors. Consequently, there has been an increasingly rich

literature dealing with such context conditions (for a survey of the literature on opportunistic

cycles, see de Haan and Klomp, 2013, and on partisan cycles under rational expectations, see

Belke, 2000).

Economically, these choices are constrained by trilemma restrictions: as an example, a fixed

exchange rate regime reduces exchange rate volatility, but results in a loss of flexibility when

it comes to a reaction of monetary policy to unexpected economic shocks in case of

unrestricted capital flows. Increasing capital mobility has often been assumed to let the

differences between left- and right-leaning governments disappear, but others show that this

is not necessarily the case (see e.g. Oatley, 1999 for an overview). Studies based on a

Mundell-Fleming framework suggest that partisan cycles in fiscal and monetary policy are

6
likely to depend on both the degree of capital mobility and the exchange rate regime (Clark

and Hallerberg, 2000; Oatley, 1999). Oatley (1999), for instance, shows that left-leaning

governments in OECD countries increase budget deficits and capital controls under conditions

of fixed exchange rate regimes, while they pursue looser monetary policies when exchange

rate regimes are more flexible.

Others have also argued that ideology effects on economic policy-making are dependent on

the economic climate that a government operates in. Lipsmeyer (2011) investigates this effect

on welfare spending and finds that governments relax their partisan preferences in recessions.

Depending on the party in government, monetary policy may also be more or less sensitive to

output gap concerns (Jones and Snyder, 2014; Clark and Arel-Bundock, 2013). However,

while the exchange rate regime, the degree of freedom of capital flows, and monetary

independence, as well as business cycle dynamics, have all featured as context conditions that

impact partisan monetary or fiscal cycles, their conditioning impact on the de facto

positioning of a country with regard to the trilemma has rarely been assessed.

Apart from trilemma restrictions and business cycle effects, other political and institutional

factors are likely to constrain the impact of partisan preferences on economic policy choices.

In this vein, the political regime type, elections, and the number of veto-players have been

found to matter (cf. Steinberg and Walter, 2013). Another important institutional constraint is

the formal independence of central banks. Central bank independence can serve as a tool for

separating social loss functions of the central bank and the government with the former

having a stronger preference for price stability. Consequently, government ideology is likely

to matter in monetary policy and exchange rate policy if central bankers are dependent on

governments’ obligations. Our sample starts in 1980, however, when formal central bank

independence increased for many economies and inflation decreased significantly. Under

conditions of central bank independence, ideology may thus no longer significantly impact

7
monetary policy. Yet, Belke and Potrafke (2012) find that leftist governments have somewhat

lower short-term nominal interest rates than right-wing governments even when central

bank independence is high, suggesting that ideology is still relevant in case of central bank

independence. Likewise, in a study on the US, Clark and Arel-Bundock (2013) find that while

the Federal Reserve is formally independent, it is not indifferent to the party in power and has

designed its monetary policy accordingly in the past.

In addition, currency board arrangements or membership in a monetary union can

simultaneously stabilize exchange rates and increase monetary policy independence from

domestic governments by fixing exchange rates against an anchor currency. Even a formally

independent central bank, however, faces de facto restrictions due exchange rate policy

decisions. In this vein, it has been argued that governments consider fixed regimes as an

instrument to safeguard monetary stability and low rates of inflation to signal their

commitment to price stability (Berdiev et al., 2012; Frieden and Stein, 2001; Levy Yeyati et

al., 2010; Frieden et al., 2001). This wisdom holds for both emerging markets and industrial

economies. In a recent study, Berdiev et al. (2012) find that left-wing governments, central

bank independence, and financial development increase the likelihood of choosing a flexible

regime. We provide a new perspective on the trilemma literature by simultaneously analysing

the de facto trilemma choices.

3. Empirical model, data, and methodology

3.1 Empirical methodology

Since we argue that a country’s position with regard to monetary independence, exchange rate

stability and capital flow restrictions in an open economy is not independent, we account for

endogeneity between these different trilemma dimensions. On the one hand, we explicitly

8
include all trilemma variables in each equation. In addition, we estimate all equations

simultaneously, accounting for cross-country correlations by relying on a 3SLS estimation

procedure (Zellner, Arnold and Theil, 1962). It combines the two-stage least squares (2SLS)

estimation approach with the seemingly unrelated regression (SUR) simultaneous equations

estimation approach. The 3SLS estimator thus addresses two possible sources of bias in our

empirical set-up. First, it allows for a consistent estimation, as it specifically addresses the

simultaneity bias that occurs due to the inclusion of all three trilemma variables, which – as

argued above – are unlikely to be independent of one another. Second, it achieves efficient

estimation of the system of simultaneous equations by using an appropriate covariance matrix

in the estimation which accounts for correlation between the different equations.

Consider the following two general equations as an example.

23 = 2"4 53 + 634 73 + 83 (2)

2" = 234 5" + 6"4 7" + 8" (3)

3SLS consists of two steps. At the first stage, the reduced form equation is estimated by OLS

regressions in order to obtain 29:4 . The obtained estimate is then used for estimating the

following equations.

23 = 29"4 53 + 634 73 + 83 (4)

2" = 2934 5" + 6"4 7" + 8" (5)

The 3SLS estimator then relies on those estimates to account for the correlation across

equations via the covariance matrix. In the present context, we estimate a three-equation

model of the trilemma variables:

;,<><?@A = 53,C + 53,3 A,- + 53," ;,<><?@A3 + 53,D @EFGH@ + 53,I J><,A@< +

53,KL + M3, (6)

9
@EFGH@ = 5",C + 5",3 A,- + 5"," ;,<><?@A + 5",D @EFGH@3 + 5",I J><,A@< + 5",K L +

M", (7)

J><,A@< = 5D,C + 5D,3 A,- + 5D," ;,<><?@A + 5D,D @EFGH@ + 5D,I J><,A@<3 +

5D,K L + MD, (8)

where ;,<><?@A , @EFGH@ and J><,A@< denote the trilemma variables, polt denotes

political economy variables, ct denotes economic control variables, and 5C denotes a constant.

All variables are explained in greater detail in the next section.

3.2 Data set and control variables

Table 1 provides an overview of the dataset for the full sample and all subsamples under

investigation. In each case, we outline the data sources and descriptive statistics.

Table 1 about here

We use the trilemma variables as constructed by Aizenman et al. (2013). They are normalized

between zero and one and defined as follows based on the classification of Aizenman et al.

(2013). Appendix A5 provides histograms of these variables for our sample.

· ;,<><?@A, i.e. monetary independence, is measured as the reciprocal of the annual

correlation between the monthly interest rate of the home country and the US, with

higher values of the index indicating a higher degree of monetary independence.

· @EFGH@, i.e. exchange rate stability is measured as the inverse of the annual standard

deviation of the monthly exchange rate between the home country and the US, with

higher values indicating a greater exchange rate stability.

10
 · J><,A@<, i.e. financial openness, is the index of capital account openness computed

by Chinn and Ito (2006, 2008). Higher values of the financial openness index entail a

greater freedom of transnational capital flows.

pol in equations 6 to 8 denotes the following set of political economy variables: Apart from

ideology, we consider elections and further constraints imposed by political institutions in

order to control for opportunistic business cycles and the general institutional background

beyond the partisan preferences of governments. The power of leftist parties in government

(leftgov) is based on original data from the Database of Political Institutions (DPI) and has

been computed as the share of seats held by left parties among the three biggest government

parties. We also consider a cross-term (leftgov*gap) assuming that the impact of partisan

preferences of governments on monetary independence, exchange rate stability, and capital

flow restrictions is mediated by the output gap. In addition to variables measuring effects of

ideology, we employ a variable measuring the remaining time that an incumbent still has in

office (incumbency). The DPI indicator only counts full years with “0” indicating an election

year, and n-1 indicating the post-election year with n being the total term length (Keefer,

2012). Further explanatory variables include a political constraints index from the Political

Constraints Index Dataset (polconstrain) (Heinsz, 2002) that measures the degree of political

and institutional checks and balances on governmental behavior. The index includes

information on the number of and the preference heterogeneity among veto players in the

executive and legislative; and hence approximates the discretion that governments have to

translate their partisan preferences into macroeconomic policy choices.

c denotes a set of economic control variables. We largely follow the modelling of monetary

policy decisions as, e.g., in Belke and Potrafke (2012), but modify their approach for a panel

based on annual data and in analogy to an extended Taylor rule. Hence, we control for the

11
annual inflation rates measured by using consumer price inflation (inflation),2 the output gap

measured by deviations of GDP growth from the average long run path based on linear

detrending (gap)3, and the current account balance approximated by the difference of exports

and imports (accountbal). Additional controls for the macroeconomic environment include a

variable for trade openness computed as the sum of imports and exports relative to GDP

(opentrade), a systemic banking crises dummy (crises), as computed by Laeven and Valencia

(2012), and an income measure (income).

Our sample covers 111 countries for the years 1980 to 2010. The full panel has only 2385

observations because it includes countries that gained independence after 1980 and can

consequently only be observed at a later point in time.4

As in other papers, we assume that trilemma interdependencies and political economy

processes may differ between developed and developing countries (see, e.g., Berdiev et al,

2012). First, we therefore provide a standard sample split into OECD and non-OECD

countries. Second, we also consider that trilemma interdependencies and associated political

economy processes may differ according to the respective trilemma regimes in place. We

allow the data to decide on the sample split in this case and conduct a cluster analysis, in

which we group all countries into two groups based on their positioning in the trilemma of de

facto monetary independence, exchange rate flexibility and the freedom of capital flows. We

use K-means cluster analysis as in the Levy-Yeyati and Sturzenegger (2005) analysis of

exchange rate regime clusters. However, we allow all trilemma variables to enter the analysis

and we enforce a two-cluster solution in order to identify the two most distinguished trilemma

2
We have adopted Inflation/(Inflation +100) as a measure to reduce the influence of hyperinflation observations
in a similar way to Samarina and Sturm (2014) and Dreher and Sturm (2012).

3
In order to prevent outliers from driving the subsequent analyses, we have excluded observations in our sample
that are associated with output gaps below -10 and above 10 percent.
4
Appendix A1 provides a list of all countries included in our sample.

12
regimes in the full sample.5 As shown in the descriptive statistics provided in Table 1, the two

clusters identified in this way are especially characterized by differences in financial

openness.6 We consequently label the respective subsamples ‘Open’ and ‘Closed’ in the

following. The OECD, Open and the non-OECD, Closed samples are relatively similar with

respect to income, but our results also suggest that there is still a number of non-OECD

countries that have relatively open capital accounts (and vice versa for OECD countries).

Trilemma interdependencies may differ between these sample splits, which may also have an

impact on how leftist parties influence macroeconomic policies. This additional data-driven

Open/Closed sample split thus provides an opportunity to compare trilemma

interdependencies and political economy processes for groups of countries divided by

financial openness rather than by income.

4. Empirical Results

4.1 Main findings

Tables 2 to 4 provide the empirical results for exchange rate stability, monetary independence,

and financial openness. We start by considering the full sample of countries displayed in

Column 1. As a second step, we consider two sample splits. The first split compares OECD

(Column 2) and non-OECD economies (Column 3). The second split compares financially

more closed (Column 4) and more open economies (Column 5). Before turning to our

estimation results, we consider the correlation of the error term across the three equations.

5
We implement the K-means++ variant developed by Arthur and Vassilvitskii (2007), which weighs the data
points according to their squared distance from the closest center already chosen and which can be shown to
outperform the standard K-means approach in terms of accuracy.
6
Appendix A2 provides a graphical presentation of the cluster characteristics. Table 1 has the descriptive
statistics for the full sample as well as for the two sample splits. As shown in Table 1, income differences in the
data driven sample split are slightly less pronounced that in the OECD/non-OECD sample split. The average
value for the index of financial openness drops from 0.40 for the non-OECD sub-sample to 0.25 for the closed
sub-sample.

13
The results display a negative correlation of 0.07 between the residual for exchange rate

stability and monetary independence, while the correlation with financial openness is -0.009

and -0.002 for exchange rate stability and monetary independence respectively. The first

correlation becomes negative if only lags of trilemma variables are considered in each

equation, a robustness test we have also undertaken. Overall, the small but existing correlation

justifies the adoption of 3SLS. However, it should be emphasized that our main findings are

not driven by the use of 3SLS. Relying on fixed effect estimates results in similar conclusions,

but a slightly weaker model fit.

The F-test statistic of the first stage regressions points to a sufficient degree of model

adequacy. To account for autocorrelation, we include one lag of the dependent variable on the

right hand side7 The R-squared suggests that our model explains a large degree of variance in

our data. The effects described in the following are robust to autocorrelation and endogeneity.

Tables 2, 3 and 4 about here

General patterns

To start with a few general patterns, the estimates for the trilemma variables display contrary

signs for exchange rate stability and monetary independence. Taking into account that both

exchange rate stability and monetary independence are measured relative to the base currency,

this demonstrates the trade-off between both policy aims. A low correlation between foreign

and domestic interest rates results in de-facto monetary independence but also in more volatile

exchange rates. This pattern is directly related to the uncovered interest parity (UIP) condition

in international capital markets which states that exchange rate changes are driven by interest

rate differentials. Although several empirical studies have shown that UIP does not hold in a

7
Compared to a specification without endogenous variables on the right-hand side, which are available upon
request, the R-squared increases significantly.

14
strict sense (see Sarno and Taylor, 2003 for an overview), there is little doubt that the

exchange rate between two economies displays lower volatility if the interest rates between

the corresponding economies are highly correlated, implying a constant interest rate

differential. Financial openness is primarily determined by its own lagged value. This is due

to little variation over time since countries rarely change their capital account policy within a

short-time period.

Economic constraints

The economic target and control variables mostly affect exchange rate stability, but partly

remain insignificant as determinants of monetary independence. Inflation has a significantly

negative effect on exchange rate stability in all samples, except for the OECD and the open

subsample. These results are in line with the observation that only high inflation rates, which

OECD countries have hardly witnessed during the great moderation period, affect exchange

rate behavior. . Inflation is also positively associated with monetary independence, and

significantly so in the full, non-OECD, and closed samples. Higher inflation may encourage

changes in monetary policy that disrupt a previously close correlation with foreign interest

rates and an anchor currency. If a country abandons a fixed exchange rate regime in case of

higher inflation, for instance, exchange rate stability decreases, while monetary independence

increases. Alternatively, countries might also decide to restrict capital flows in case of higher

inflation, as suggested by the mainly significant and negative coefficient of inflation in Table

4.

The output gap mostly has a positive and significant effect on exchange rate stability, but

remains constantly insignificant for monetary independence. Finally, increases in income are

inversely related to exchange rate stability and monetary independence over the full sample.

Political and Institutional Constraints

15
Variables associated with political and institutional constraints apart from government

ideology do not seem to be important in determining the position of a country within the

trilemma. Coming closer to the end of an incumbent’s term (decreasing values of

incumbency) and hence, closer to election day, seems to go along with more exchange rate

flexibility in OECD countries (Table 2), but this result is not robust to different sampling

periods or estimation techniques (see Appendices A3 and A4). Monetary independence (Table

3) and financial openness (Table 4) seem to remain unaffected from election effects. Political

constraints in terms of further political and institutional checks and balances hardly seem to

affect a country’s trilemma position in a consistent or significant way.

Turning to the variable of main interest here - leftgov -, our results suggest highly context-

dependent effects of ideology on a country’s position in the trilemma of monetary

independence, exchange rate stability and freedom of capital flows. First, the coefficients of

leftgov in Tables 2 to 4 show the effect of partisan preferences on the different trilemma

dimensions if the output gap is zero (cf. Brambor et al., 2006). Its values suggest that there is

no partisan effect that is consistent and significant across all samples. Instead, we find that in

cases of an output gap of zero – which roughly corresponds to its mean value in our full

sample - more left-leaning governments are only consistently associated with significantly

more exchange rate flexibility in ‘Closed’-countries (Table 2, ‘Closed’). There is no

significant or substantial partisan effect on monetary independence and financial openness at

this stage of the business cycle. In economically ‘normal’ times ideology thus seems to exert a

significant impact on exchange rate stability in this subsample, but not on monetary

independence, or financial openness if the joint determination of both is considered, as done

in our 3-stage approach.

How do these effects vary with changing business cycles? In order to answer this question,

Figure 1 provides marginal effect plots (based on Brambor (2013)) for our 3SLS estimations.

16
They display the coefficient of leftgov at different values of gap with respect to exchange rate

stability, monetary independence, and financial openness, respectively.

Figure 1 about here

The plots first show the trade-off between exchange rate stability and monetary independence:

More left-leaning governments are associated with less exchange rate stability and more

monetary independence the more the country’s output gap turns positive over the full sample.

On the contrary, more left-leaning governments seem to increasingly favor exchange rate

stability over monetary independence, the greater the economic downturn. There is no similar

pattern detectable with regard to the impact of partisan preferences on financial openness.

Our results thereby contextualize the classic assumption that left-leaning governments favor

exchange rate flexibility and monetary independence. It shows that the effect of partisan

preferences on the de facto exchange rate flexibility and monetary independence are highly

contingent on business cycle dynamics. This is in line with previous studies arguing that

governments relax their partisan preferences in times of economic downturns (Lipsmeyer,

2011). Our results further suggest that partisan preferences may even be reversed in

economically tight times. The finding that left-leaning governments prefer less flexible

exchange rates in times of a negative output gaps might reflect that they try to prevent

fluctuations of the domestic currency potentially resulting from measures designed to

stimulate the economy. Taking both effects into account against the background of a potential

loss-function, this suggests that exchange rate stability is considered to be more beneficial

compared to monetary independence in case of a negative output gap.

The marginal effect plots also show, however, that these findings vary across different

samples. In the OECD sample, they are mostly substantial and significant for exchange rate

stability (Figure 1, second row), but not for monetary independence. In the non-OECD sample

17
(Figure 1, third row), however, the marginal effect plots display roughly the same direction of

coefficients for leftgov at the respective values of output gap, but they mostly fail to be

significantly different from zero and are smaller in size. Results for the non-OECD cluster are

similar to the results for the closed sub-sample, and differ from results for the open sub-

sample, for instance, with regard to the partisan impact on exchange rate stability8. In sum,

our regressions thus show the heterogeneity of the impact of ideology on a country’s position

in the trilemma of monetary independence, exchange rate stability, and the freedom of capital

flows in different country samples and business cycle stages. While financial openness

remains unaffected by ideology effects, even when controlling for these contexts, we observe

conditional partisan effects on monetary independence and the corresponding inverse effect

on exchange rate stability, at least for the full, and partly for the OECD samples.

4.2 Robustness tests, subsamples

We have carried out several tests to check for the robustness and validity of our results. First,

we have conducted separate fixed effects estimations with and without lags of the trilemma

variables. The findings are presented in Tables A3.1 to A3.3 and provide a substantially lower

explanatory power compared to our main findings. Coefficients mostly display the same

magnitude but are less significant. In the full sample, the ideology effects as described above

are only significant in the case of monetary independence (Appendix A6).

As an additional robustness test, we also consider estimations for two different sample periods

in Appendix A4. We exclude the period after the collapse of Lehman Brothers and the period

of economic transformations during the eighties. We compare the respective estimations

8
The subsample results for marginal effects are not shown in the main paper due to space constraints. They are
available upon request.

18
results of leftgov, representing the impact of partisanship on exchange rate stability, monetary

independence and capital flows if the output gap is zero, with those of our original 3SLS

estimation. Disregarding the recent crisis period provides similar effects of ideology. If we

disregard the 1980s, the effects on exchange rate stability gain in significance in the full

sample and the non-OECD sample, but otherwise remain similar. When comparing the

direction of the interaction term (leftgov*gap), we still observe the reversed effects on

monetary independence and exchange rate stability for all subsamples. Finally, we estimated

all equations with all three trilemma variables lagged instead of considering the other two

trilemma variables contemporaneously in each equation. The results remain essentially

unchanged and are available upon request.

5. Conclusions

This paper has reconsidered the policy trilemma in an open economy by incorporating

political economy concerns. We argue that the impact of government ideology on monetary

independence, exchange rate stability, and capital flow restrictions should be analyzed in the

broader context of restrictions imposed by the impossible trinity. Our results further elucidate

that the government ideology affects a country’s position in this trilemma in a highly context

dependent manner: we show that the impact of partisan preferences on exchange rate stability

and monetary independence is contingent on the stance of the respective economy’s business

cycle. Left-leaning governments seem to favor exchange rate stability over monetary

independence in case of a negative output gap; suggesting a reversal of their commonly

assumed partisan preferences in economically tight times. We also show that the impact of

government ideology on these two trilemma components varies between developed and

developing countries. Besides a split of OECD versus non OECD countries, we also consider

a cluster-based distinction between financially open and closed sub-samples.

19
Overall, we argue that the analysis of ideology effects on monetary independence, exchange

rate stability, and capital flow restrictions should be carried out in the context of a joint

determination of the trilemma variables. The importance of simultaneous modelling trilemma

restrictions is of general importance and does not depend on the 3SLS framework. Moreover,

we consider their de facto measures instead of de jure measures (such as central bank

independence or exchange rate regimes). While a detailed comparison of de facto and de jure

measures has been beyond the scope of this paper, it may be a valuable avenue for future

research.

20
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 Table 1: Descriptive statistics

Full sample OECD Non-OECD Closed Open

Name Definition Source Mean Std Min Max Mean Std Mean Std Mean Std Mean Std
Monetary independence
monindep ACI 0.42 0.20 0.00 0.96 0.32 0.21 0.48 0.16 0.51 0.15 0.31 0.19
index
Exchange rate stability
exrate ACI 0.56 0.30 0.01 1.00 0.53 0.29 0.57 0.31 0.54 0.31 0.59 0.30
Index
finopen Financial openness index ACI 0.51 0.36 0.00 1.00 0.74 0.32 0.40 0.32 0.25 0.18 0.87 0.20
Share of the seats of the
three biggest government DPI, own
leftgov 0.33 0.43 0.00 1.00 0.43 0.43 0.28 0.42 0.32 0.43 0.34 0.43
parties Leftist power in calc.
government
Henisz
polconstrain Political constraints index 0.34 0.19 0.00 0.72 0.45 0.13 0.28 0.19 0.29 0.19 0.40 0.17
(2002)
incumbency Years left in current term DPI 1.97 1.45 0.00 7.00 1.73 1.31 2.09 1.51 2.10 1.53 1.79 1.32
WDI, own
inflation Inflation/(Inflation +100) 0.09 0.13 -0.13 0.99 0.07 0.09 0.11 0.14 0.13 0.15 0.05 0.06
calc.
-
accountbal Current Account / GDP OECD -3.68 11.23 42.31 0.38 5.41 -5.80 12.78 -5.34 11.53 -1.55 10.48
100.97
Output gap based on UNCTAD/
gap 0.22 3.18 -9.80 9.99 -0.05 2.59 0.37 3.44 0.22 3.33 0.24 2.98
linear detrending own calc.
opentrade Imports + exports/ GDP UNCTAD 75.33 48.90 12.66 445.62 72.48 36.15 76.82 54.32 65.40 34.13 89.11 61.53
Laeven /
Systemic banking crises
crises Valencia 0.09 0.29 0.00 1.00 0.12 0.33 0.08 0.27 0.10 0.29 0.09 0.29
dummy
(2012)
income log gdp per capita UNCTAD 8.16 1.66 4.48 11.12 9.97 0.66 7.22 1.16 7.42 1.40 9.14 1.43

Note: ACI= Aizenman/Chinn/ Ito (2010), DPI= Database of Political Institutions (Keefer 2012), WDI=World Development Indicators; Number of observations by sample: 2385 (full
sample); 817 (OECD), 1568 (non-OECD); 1367 (Closed), 999 (Open).

28
Table 2: Political and economic determinants of exchange rate stability (1980-2010)

EXRATE Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep -0.157*** -0.238*** -0.104** -0.070 -0.188***
(0.000) (0.000) (0.010) (0.188) (0.000)
Exratel 0.768*** 0.756*** 0.755*** 0.713*** 0.817***
(0.000) (0.000) (0.000) (0.000) (0.000)
Openfinance -0.002 -0.010 -0.006 -0.043 0.044
(0.905) (0.690) (0.741) (0.235) (0.132)
Ideology Leftgov -0.009 0.005 -0.019 -0.033*** 0.015
(0.265) (0.642) (0.107) (0.008) (0.174)
Leftgov*gap -0.005* -0.011** -0.003 -0.004 -0.007*
(0.051) (0.023) (0.369) (0.349) (0.058)
Political Controls Polconstrain 0.024 -0.014 0.022 0.003 0.045
(0.247) (0.734) (0.405) (0.924) (0.140)
Incumbency 0.003 0.010*** 0.001 0.004 0.002
(0.168) (0.007) (0.659) (0.243) (0.642)
Economic Targets Inflation -0.141*** -0.083 -0.171*** -0.188*** 0.012
(0.000) (0.243) (0.000) (0.000) (0.892)
Accountbal 0.000 -0.000 0.000 0.001* -0.000
(0.167) (0.982) (0.518) (0.055) (0.943)
Gap 0.006*** 0.006** 0.005*** 0.006*** 0.003
(0.000) (0.014) (0.001) (0.000) (0.119)
Economic Controls Opentrade 0.000 0.001*** -0.000 0.000 0.000
(0.152) (0.002) (0.858) (0.165) (0.139)
Crises -0.014 -0.029* -0.008 -0.021 -0.014
(0.266) (0.066) (0.635) (0.235) (0.396)
Income -0.012*** -0.007 -0.005 -0.012*** -0.015***
(0.000) (0.517) (0.354) (0.010) (0.002)
Constant 0.288*** 0.245** 0.245*** 0.298*** 0.244***
(0.000) (0.028) (0.000) (0.000) (0.000)
R-squared 0.682 0.768 0.646 0.625 0.769
Note: Estimates for Table 2 are carried out jointly using 3SLS. See Table 1 and Section 4 for
abbreviations. P-values are given in Parentheses- *, **, *** denote significances at the 10%, 5%, and
1% level.

29
Table 3: Political and economic determinants of monetary independence (1980-2010)

MONINDEP Full Sample OECD Non-OECD Closed Open

Trilemma MonIndepl 0.739*** 0.675*** 0.710*** 0.635*** 0.671***
(0.000) (0.000) (0.000) (0.000) (0.000)
Exrate -0.039*** -0.146*** 0.004 0.014 -0.097***
(0.000) (0.000) (0.763) (0.366) (0.000)
Openfinance -0.022** -0.050*** 0.003 0.148*** 0.119***
(0.012) (0.007) (0.790) (0.000) (0.000)
Ideology Leftgov -0.007 -0.006 0.002 0.006 -0.005
(0.188) (0.522) (0.790) (0.443) (0.555)
Leftgov*gap 0.004** 0.006 0.003 0.001 0.008***
(0.042) (0.126) (0.106) (0.736) (0.003)
Political Controls Polconstrain -0.001 -0.007 0.007 0.025 -0.032
(0.952) (0.838) (0.666) (0.130) (0.159)
Incumbency -0.000 0.003 -0.002 -0.002 0.000
(0.842) (0.294) (0.404) (0.382) (0.992)
Economic Targets Inflation 0.053** 0.036 0.067*** 0.073*** 0.096
(0.012) (0.527) (0.005) (0.001) (0.126)
Accountbal 0.000 -0.000 0.000 0.000 0.000
(0.225) (0.907) (0.147) (0.445) (0.885)
Gap 0.001 0.001 0.001 0.001 -0.001
(0.285) (0.717) (0.359) (0.322) (0.720)
Economic Controls Opentrade 0.000 0.000 -0.000 -0.000 0.000
(0.574) (0.760) (0.707) (0.991) (0.391)
Crises -0.006 0.000 -0.007 -0.003 -0.005
(0.463) (0.975) (0.546) (0.758) (0.700)
Income -0.010*** -0.009 -0.005 -0.003 -0.015***
(0.000) (0.250) (0.161) (0.210) (0.000)
Constant 0.224*** 0.305*** 0.165*** 0.157*** 0.192***
(0.000) (0.000) (0.000) (0.000) (0.000)
R-squared 0.667 0.730 0.528 0.490 0.703
Note: See Table 2

30
Table 4: Political and economic determinants of financial openness (1980-2010)

FINOPEN Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep 0.009 0.020 0.008 0.091*** 0.085***
(0.554) (0.485) (0.675) (0.000) (0.000)
Exrate -0.014 0.011 -0.016 -0.026** 0.019*
(0.111) (0.558) (0.139) (0.037) (0.099)
Openfinancel 0.949*** 0.902*** 0.960*** 0.838*** 0.807***
(0.000) (0.000) (0.000) (0.000) (0.000)
Ideology Leftgov 0.000 0.006 -0.003 -0.003 -0.007
(0.976) (0.354) (0.600) (0.603) (0.185)
Leftgov*gap -0.001 0.003 -0.001 -0.000 -0.002
(0.596) (0.309) (0.406) (0.839) (0.248)
Political Controls Polconstrain 0.013 0.000 0.007 0.013 -0.013
(0.220) (0.987) (0.584) (0.318) (0.374)
Incumbency -0.001 -0.002 -0.001 -0.001 0.001
(0.555) (0.471) (0.689) (0.648) (0.464)
Economic Targets Inflation -0.043*** -0.269*** -0.014 -0.056*** 0.021
(0.007) (0.000) (0.459) (0.002) (0.612)
Accountbal -0.000* 0.001 -0.000** -0.000 0.000
(0.070) (0.305) (0.045) (0.326) (0.991)
Gap 0.002** -0.003* 0.002*** 0.001 0.002**
(0.026) (0.058) (0.002) (0.316) (0.014)
Economic Controls Opentrade 0.000 0.000 0.000 0.000** -0.000*
(0.209) (0.389) (0.726) (0.012) (0.081)
Crises -0.007 -0.022** -0.003 -0.011 0.007
(0.242) (0.012) (0.761) (0.175) (0.393)
Income 0.009*** -0.003 0.009*** 0.005*** 0.011***
(0.000) (0.568) (0.001) (0.010) (0.000)
Constant -0.034* 0.123* -0.037 -0.037 0.053*
(0.077) (0.059) (0.103) (0.117) (0.055)
R-squared 0.942 0.940 0.924 0.776 0.872
Note: See Table 2

31
Figure 1: Marginal effect plots for 3SLS

Marginal effect on 'exrate' Marginal effect on 'monindep' Marginal effect on 'finopen'

.1
.1

.1
15
15

15

10
10

10

0
0

5
5

% of observations of 'gap'
% of observations of 'gap'

% of observations of 'gap'

-.1
0
0

-.1

-.1
-10 0 10 -10 0 10 -10 -5 0 5 10
Output gap Output gap Output gap

Marginal effect on 'exrate', OECD sample Marginal effect on 'monindep', OECD sample Marginal effect on 'finopen', OECD sample

.1

.1

20
20
15

15
15

.1
0
0
10

10
10

0
5

5
5

-.1
-.1

% of observations of 'gap'
% of observations of 'gap'
% of observations of 'gap'

0
0
0

-.1

-10 0 10 -10 0 10 -10 0 10

Output gap Output gap Output Gap

Marginal effect on 'exrate', non-OECD sample Marginal effect on 'monindep', non-OECD sample Marginal effect on 'finopen', non-OECD sample

.1
.1
.1

20
20
20

15
15
15

0
0
0

10
10
10

5
5
5

% of observations of 'gap'
% of observations of 'gap'
% of observations of 'gap'

-.1
0
0
0

-.1
-.1

-10 0 10 -10 0 10 -10 0 10

Output gap Output gap Output gap

32
Appendix A1: List of 111 sample countries
Albania, Algeria, Angola, Argentina, Armenia, Australia, Austria, Azerbaijan,
Bangladesh, Belgium, Benin, Bolivia, Botswana, Brazil, Bulgaria, Burkina Faso,
Burundi, Cambodia, Cameroon, Canada, Chad, Chile, Colombia, Costa Rica,
Croatia, Cyprus, Czech Republic, Denmark, Ecuador, El Salvador, Estonia, Ethiopia,
Fiji, Finland, France, Gabon, Georgia, Germany (1990-), Ghana, Greece, Guatemala,
Guinea-Bissau, Guyana, Haiti, Honduras, Hungary, Iceland, India, Indonesia, Ireland,
Israel, Italy, Jamaica, Japan, Kazakhstan, Kenya, Kyrgyz Republic, Latvia, Lesotho,
Lithuania, Madagascar, Malawi, Malaysia, Mali, Mauritania, Mauritius, Mexico,
Moldova, Mongolia, Mozambique, Myanmar, Namibia, Nepal, Netherlands, New
Zealand, Nicaragua, Niger, Nigeria, Norway, Pakistan, Panama, Paraguay, Peru,
Philippines, Poland, Portugal, Romania, Rwanda, Senegal, Sierra Leone, Singapore,
Slovak Republic, Slovenia, South Africa, Spain, Sri Lanka, Sweden, Switzerland,
Tajikistan, Tanzania, Thailand, Togo, Tunisia, Turkey, Uganda, Ukraine, United
Kingdom, Uruguay, Vietnam, Zambia, Zimbabwe.

Appendix A2: Cluster characteristics

1

1
.5

.5
0

0 .5 1 0 .5 1
Monetary independence Monetary independence
Open Closed Open Closed
1
.5
0

0 .5 1
Exchange rate stability
Open Closed

33
Appendix A3: Fixed effects regressions

Table A3.1: Fixed effects regression of exchange rate stability

EXRATE Lag Gap Lag&Gap No Cons. Single Cons.

Trilemma MonIndep -0.166*** -0.270*** -0.165*** -0.170***
(0.000) (0.000) (0.000) (0.000)
FinOpen 0.025 0.038 0.025
(0.315) (0.405) (0.309)
Exratel 0.505*** 0.506*** 0.529*** 0.506***
(0.000) (0.000) (0.000) (0.000)
Ideology Leftgov -0.002 -0.020 -0.002 -0.001 -0.001
(0.858) (0.331) (0.886) (0.958) (0.913)
Leftgov*gap -0.001 -0.002 -0.004 -0.002
(0.834) (0.535) (0.347) (0.546)
Political Controls Polconstrain 0.078** 0.093 0.078** 0.069* 0.078**
(0.045) (0.128) (0.044) (0.076) (0.043)
Incumbency 0.002 0.003 0.002 0.002 0.002
(0.410) (0.301) (0.401) (0.416) (0.398)
Economic Targets Inflation -0.212*** -0.397*** -0.214*** -0.231*** -0.229***
(0.001) (0.000) (0.001) (0.000) (0.000)
Accountbal 0.001 -0.000 0.001 0.001 0.001
(0.160) (0.675) (0.141) (0.162) (0.179)
Gap 0.005*** 0.006*** 0.006*** 0.006*** 0.006***
(0.000) (0.007) (0.000) (0.000) (0.000)
Economic Controls Opentrade 0.000 0.001 0.000 0.000 0.000
(0.475) (0.305) (0.464) (0.276) (0.439)
Crises -0.015 -0.009 -0.015 -0.013 -0.016
(0.276) (0.674) (0.275) (0.394) (0.262)
Income -0.021 0.012 -0.021 0.012 -0.011
(0.352) (0.785) (0.349) (0.649) (0.623)
Constant 0.481*** 0.524 0.482*** 0.145 0.419**
(0.008) (0.125) (0.008) (0.503) (0.025)
Observations 2,385 2,415 2,385 2,385 2,385
R-squared 0.363 0.137 0.370 0.353 0.369
Number of country 111 111 111 111 111
Time Periods 31 31 31 31 31
Robust p-values in parentheses
*** p<0.01, ** p<0.05, * p<0.1

34
Table A3.2: Fixed effects regression of monetary independence

MONINDEP Lag Gap Lag&Gap No Cons. Single Cons.

Trilemma FinOpen -0.049*** -0.121*** -0.050***
(0.000) (0.000) (0.000)
Exrate -0.058*** -0.170*** -0.058*** -0.059***
(0.000) (0.000) (0.000) (0.000)
MonIndepl 0.649*** 0.648*** 0.673*** 0.656***
(0.000) (0.000) (0.000) (0.000)
Ideology Leftgov 0.006 -0.001 0.005 0.005 0.004
(0.465) (0.972) (0.540) (0.514) (0.609)
Leftgov*gap 0.007** 0.006*** 0.006*** 0.005***
(0.033) (0.003) (0.004) (0.005)
Political Controls Polconstrain 0.024 0.063* 0.024 0.019 0.024
(0.126) (0.079) (0.119) (0.241) (0.121)
Incumbency 0.000 0.001 0.000 0.000 0.000
(0.810) (0.584) (0.861) (0.952) (0.871)
Economic Targets Inflation -0.003 -0.093* 0.002 0.059** 0.033
(0.903) (0.064) (0.924) (0.014) (0.148)
Accountbal 0.000 -0.000 0.000 0.000 0.000
(0.629) (0.769) (0.829) (0.388) (0.454)
Gap 0.002** 0.001 0.001 0.001 0.001
(0.011) (0.508) (0.376) (0.397) (0.251)
Economic Controls Opentrade -0.000** -0.000 -0.000** -0.000** -0.000**
(0.041) (0.201) (0.036) (0.018) (0.032)
Crises -0.010 -0.022 -0.010 -0.009 -0.009
(0.200) (0.130) (0.203) (0.277) (0.234)
Income -0.024* -0.080** -0.024* -0.044*** -0.043***
(0.061) (0.011) (0.069) (0.002) (0.002)
Constant 0.419*** 1.250*** 0.415*** 0.516*** 0.542***
(0.000) (0.000) (0.000) (0.000) (0.000)
Observations 2,385 2,415 2,385 2,385 2,385
R-squared 0.497 0.120 0.499 0.490 0.495
Number of country 111 111 111 111 111
Time Periods 31 31 31 31 31
Robust p-values in parentheses
*** p<0.01, ** p<0.05, * p<0.1

35
Table A3.3: Fixed effects regression of financial openness
Single
FINOPEN Lag Gap Lag&Gap No Cons.
Cons.
Trilemma MonIndep -0.019 -0.177*** -0.019
(0.100) (0.000) (0.106)
Exrate -0.016 0.035 -0.016 -0.013
(0.190) (0.398) (0.190) (0.295)
FinOpenl 0.873*** 0.873*** 0.874*** 0.875***
(0.000) (0.000) (0.000) (0.000)
Ideology Leftgov 0.004 0.014 0.004 0.005 0.004
(0.497) (0.633) (0.489) (0.464) (0.486)
Leftgov*gap 0.003 -0.000 -0.000 -0.000
(0.566) (0.883) (0.838) (0.823)
Political Controls Polconstrain 0.002 0.003 0.002 -0.001 0.000
(0.935) (0.962) (0.936) (0.975) (0.983)
Incumbency -0.000 0.000 -0.000 -0.000 -0.000
(0.956) (0.787) (0.961) (0.919) (0.950)
Economic Targets Inflation -0.110*** -0.599*** -0.111*** -0.104*** -0.109***
(0.000) (0.000) (0.000) (0.000) (0.000)
Accountbal -0.001* -0.004** -0.001* -0.001* -0.001*
(0.078) (0.012) (0.082) (0.085) (0.082)
Gap 0.001 -0.005** 0.001 0.001 0.001
(0.208) (0.017) (0.280) (0.330) (0.288)
Economic Controls Opentrade 0.000 0.000 0.000 0.000 0.000
(0.915) (0.748) (0.913) (0.915) (0.880)
Crises -0.011 -0.018 -0.011 -0.011 -0.011
(0.166) (0.400) (0.166) (0.185) (0.181)
Income 0.034** 0.384*** 0.034** 0.035** 0.035**
(0.042) (0.000) (0.042) (0.035) (0.034)
Constant -0.180 -2.547*** -0.180 -0.208 -0.204
(0.167) (0.000) (0.168) (0.112) (0.118)
Observations 2,385 2,415 2,385 2,385 2,385
R-squared 0.847 0.326 0.847 0.847 0.847
Number of country 111 111 111 111 111
Time Periods 31 31 31 31 31
Robust p-values in parentheses,
*** p<0.01, ** p<0.05, * p<0.1

36
Appendix A4: 3SLS regressions with different time periods

Table A4.1: Political and economic determinants of exchange rate stability (1980-2008)

EXRATE Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep -0.149*** -0.238*** -0.093** -0.055 -0.193***
(0.000) (0.000) (0.028) (0.320) (0.000)
Exratel 0.770*** 0.749*** 0.757*** 0.714*** 0.820***
(0.000) (0.000) (0.000) (0.000) (0.000)
Openfinance -0.007 -0.011 -0.013 -0.044 0.038
(0.616) (0.654) (0.476) (0.248) (0.216)
Ideology Leftgov -0.009 0.007 -0.019 -0.027** 0.011
(0.334) (0.579) (0.138) (0.035) (0.387)
Leftgov*gap -0.004 -0.012** -0.002 -0.003 -0.008*
(0.150) (0.029) (0.570) (0.438) (0.095)
Political Controls Polconstrain 0.020 -0.016 0.021 -0.001 0.035
(0.361) (0.711) (0.435) (0.986) (0.276)
Incumbency 0.004* 0.010** 0.002 0.005 0.002
(0.099) (0.010) (0.470) (0.140) (0.642)
Economic Targets Inflation -0.131*** -0.056 -0.164*** -0.185*** 0.061
(0.000) (0.445) (0.000) (0.000) (0.482)
Accountbal 0.000 0.000 0.000 0.001* -0.000
(0.247) (0.947) (0.662) (0.081) (0.738)
Gap 0.006*** 0.010*** 0.005*** 0.006*** 0.005**
(0.000) (0.001) (0.002) (0.001) (0.018)
Economic Controls Opentrade 0.000 0.000** 0.000 0.000 0.000
(0.190) (0.012) (0.970) (0.135) (0.209)
Crises -0.019 -0.035* -0.008 -0.026 -0.010
(0.154) (0.058) (0.652) (0.154) (0.630)
Income -0.010*** -0.003 -0.004 -0.011** -0.011**
(0.004) (0.819) (0.485) (0.018) (0.043)
Constant 0.270*** 0.210* 0.227*** 0.279*** 0.205***
(0.000) (0.079) (0.000) (0.000) (0.000)
R-squared 0.673 0.750 0.641 0.619 0.760
Note: See Table 2

37
Table A4.2: Political and economic determinants of exchange rate stability (1990-2010)

EXRATE Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep -0.160*** -0.220*** -0.099** -0.095 -0.165***
(0.000) (0.000) (0.023) (0.126) (0.000)
Exratel 0.777*** 0.796*** 0.748*** 0.703*** 0.832***
(0.000) (0.000) (0.000) (0.000) (0.000)
Openfinance -0.002 0.019 -0.016 -0.047 0.037
(0.900) (0.519) (0.413) (0.278) (0.270)
Ideology Leftgov -0.018* -0.007 -0.025* -0.052*** 0.013
(0.060) (0.545) (0.068) (0.001) (0.256)
Leftgov*gap -0.004 -0.004 -0.003 -0.000 -0.008*
(0.265) (0.421) (0.461) (0.917) (0.059)
Political Controls Polconstrain 0.021 0.012 0.018 -0.009 0.046
(0.367) (0.787) (0.531) (0.784) (0.160)
Incumbency 0.002 0.006 0.001 0.003 0.000
(0.370) (0.109) (0.681) (0.425) (0.916)
Economic Targets Inflation -0.120*** 0.066 -0.170*** -0.171*** -0.041
(0.003) (0.523) (0.000) (0.001) (0.681)
Accountbal 0.000 -0.001 0.000 0.001* -0.000
(0.345) (0.189) (0.651) (0.098) (0.744)
Gap 0.006*** 0.005* 0.005*** 0.008*** 0.003
(0.000) (0.052) (0.003) (0.001) (0.186)
Economic Controls Opentrade 0.000 0.000** 0.000 0.000 0.000
(0.181) (0.013) (0.834) (0.141) (0.151)
Crises -0.015 -0.024 -0.011 -0.017 -0.023
(0.278) (0.122) (0.602) (0.418) (0.171)
Income -0.012*** 0.000 -0.006 -0.015*** -0.015***
(0.002) (0.993) (0.319) (0.009) (0.006)
Constant 0.291*** 0.120 0.260*** 0.349*** 0.234***
(0.000) (0.336) (0.000) (0.000) (0.000)
R-squared 0.699 0.829 0.643 0.634 0.788
Note: See Table 2

38
Table A4.3: Political and economic determinants of exchange rate stability (1990-2008)

EXRATE Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep -0.150*** -0.220*** -0.085* -0.079 -0.165***
(0.000) (0.000) (0.065) (0.235) (0.000)
Exratel 0.781*** 0.797*** 0.750*** 0.705*** 0.838***
(0.000) (0.000) (0.000) (0.000) (0.000)
Openfinance -0.010 0.014 -0.026 -0.049 0.030
(0.558) (0.652) (0.212) (0.284) (0.402)
Ideology Leftgov -0.020* -0.010 -0.026* -0.045*** 0.007
(0.057) (0.455) (0.079) (0.005) (0.624)
Leftgov*gap -0.001 -0.001 -0.002 0.000 -0.007
(0.702) (0.813) (0.723) (0.967) (0.149)
Political Controls Polconstrain 0.017 0.023 0.019 -0.012 0.036
(0.492) (0.622) (0.542) (0.734) (0.301)
Incumbency 0.003 0.006 0.003 0.005 0.000
(0.240) (0.123) (0.485) (0.259) (0.949)
Economic Targets Inflation -0.101** 0.128 -0.162*** -0.167*** 0.033
(0.014) (0.228) (0.001) (0.001) (0.748)
Accountbal 0.000 -0.002 0.000 0.001 -0.000
(0.534) (0.177) (0.860) (0.142) (0.491)
Gap 0.007*** 0.010*** 0.006*** 0.008*** 0.005**
(0.000) (0.002) (0.004) (0.001) (0.029)
Economic Controls Opentrade 0.000 0.000 0.000 0.000 0.000
(0.246) (0.142) (0.657) (0.120) (0.225)
Crises -0.023 -0.029 -0.011 -0.023 -0.022
(0.135) (0.118) (0.624) (0.294) (0.289)
Income -0.009** 0.009 -0.005 -0.015** -0.009
(0.024) (0.463) (0.481) (0.015) (0.121)
Constant 0.264*** 0.029 0.236*** 0.329*** 0.181***
(0.000) (0.827) (0.000) (0.000) (0.003)
R-squared 0.690 0.820 0.636 0.626 0.781
Note: See Table 2

39
Table A4.4: Political and economic determinants of monetary policy independence (1980-
2008)

MONINDEP Full Sample OECD Non-OECD Closed Open

Trilemma MonIndepl 0.744*** 0.678*** 0.717*** 0.635*** 0.671***
(0.000) (0.000) (0.000) (0.000) (0.000)
Exrate -0.033*** -0.144*** 0.011 0.022 -0.100***
(0.005) (0.000) (0.438) (0.162) (0.000)
Openfinance -0.025*** -0.049** 0.000 0.150*** 0.114***
(0.007) (0.011) (0.970) (0.000) (0.000)
Ideology Leftgov -0.004 -0.004 0.006 0.006 -0.002
(0.514) (0.639) (0.440) (0.397) (0.786)
Leftgov*gap 0.003 0.004 0.003 0.001 0.007**
(0.139) (0.319) (0.167) (0.573) (0.026)
Political Controls Polconstrain 0.003 -0.006 0.008 0.024 -0.025
(0.859) (0.860) (0.637) (0.155) (0.294)
Incumbency -0.001 0.002 -0.001 -0.002 -0.000
(0.765) (0.486) (0.479) (0.383) (0.894)
Economic Targets Inflation 0.049** 0.019 0.065*** 0.073*** 0.104
(0.022) (0.739) (0.007) (0.002) (0.105)
Accountbal 0.000 -0.000 0.000 0.000 0.000
(0.433) (0.940) (0.302) (0.722) (0.914)
Gap 0.001 -0.000 0.001 0.001 -0.000
(0.354) (0.936) (0.385) (0.535) (0.882)
Economic Controls Opentrade 0.000 0.000 -0.000 -0.000 0.000
(0.760) (0.724) (0.530) (0.859) (0.599)
Crises -0.004 -0.010 -0.005 -0.004 -0.003
(0.657) (0.509) (0.656) (0.699) (0.846)
Income -0.010*** -0.015* -0.005 -0.003 -0.016***
(0.000) (0.096) (0.172) (0.193) (0.000)
Constant 0.219*** 0.355*** 0.159*** 0.156*** 0.197***
(0.000) (0.000) (0.000) (0.000) (0.000)
R-squared 0.660 0.719 0.528 0.485 0.685
Note: See Table 2

40
Table A4.5: Political and economic determinants of monetary policy independence (1990-
2010)

MONINDEP Full Sample OECD Non-OECD Closed Open

Trilemma MonIndepl 0.739*** 0.673*** 0.712*** 0.617*** 0.672***
(0.000) (0.000) (0.000) (0.000) (0.000)
Exrate -0.048*** -0.155*** 0.000 0.018 -0.100***
(0.000) (0.000) (0.981) (0.369) (0.000)
Openfinance -0.019* -0.062** 0.007 0.185*** 0.139***
(0.079) (0.019) (0.555) (0.000) (0.000)
Ideology Leftgov -0.012* -0.011 -0.003 -0.004 -0.008
(0.088) (0.315) (0.746) (0.675) (0.348)
Leftgov*gap 0.005** 0.009* 0.004* 0.003 0.009***
(0.032) (0.054) (0.092) (0.294) (0.003)
Political Controls Polconstrain -0.002 -0.010 0.005 0.019 -0.037
(0.926) (0.801) (0.776) (0.350) (0.136)
Incumbency 0.001 0.004 -0.001 -0.001 0.000
(0.772) (0.254) (0.760) (0.688) (0.931)
Economic Targets Inflation 0.049* 0.047 0.080** 0.091*** 0.055
(0.085) (0.616) (0.012) (0.004) (0.465)
Accountbal 0.000 -0.001 0.000 0.000 -0.000
(0.252) (0.412) (0.186) (0.708) (0.937)
Gap 0.001 0.000 0.001 0.001 -0.000
(0.176) (0.907) (0.250) (0.298) (0.874)
Economic Controls Opentrade 0.000 0.000 -0.000 -0.000 0.000
(0.212) (0.160) (0.996) (0.978) (0.118)
Crises -0.005 0.001 -0.008 -0.003 -0.003
(0.609) (0.966) (0.564) (0.813) (0.793)
Income -0.013*** -0.001 -0.006 0.001 -0.018***
(0.000) (0.912) (0.142) (0.887) (0.000)
Constant 0.239*** 0.220** 0.168*** 0.128*** 0.189***
(0.000) (0.045) (0.000) (0.000) (0.000)
R-squared 0.686 0.741 0.529 0.491 0.725
Note: See Table 2

41
Table A4.6: Political and economic determinants of monetary policy independence (1990-
2008)

MONINDEP Full Sample OECD Non-OECD Closed Open

Trilemma MonIndepl 0.747*** 0.677*** 0.721*** 0.613*** 0.674***
(0.000) (0.000) (0.000) (0.000) (0.000)
Exrate -0.041*** -0.154*** 0.009 0.029 -0.102***
(0.003) (0.000) (0.604) (0.158) (0.000)
Openfinance -0.022* -0.065** 0.005 0.194*** 0.133***
(0.053) (0.021) (0.710) (0.000) (0.000)
Ideology Leftgov -0.007 -0.010 0.002 -0.005 -0.007
(0.337) (0.385) (0.821) (0.640) (0.455)
Leftgov*gap 0.004 0.009 0.004 0.004 0.009**
(0.108) (0.122) (0.153) (0.149) (0.018)
Political Controls Polconstrain 0.002 -0.009 0.006 0.016 -0.028
(0.887) (0.830) (0.761) (0.448) (0.296)
Incumbency 0.000 0.003 -0.000 -0.001 -0.000
(0.820) (0.443) (0.894) (0.718) (0.964)
Economic Targets Inflation 0.046 0.033 0.078** 0.091*** 0.078
(0.118) (0.730) (0.017) (0.005) (0.319)
Accountbal 0.000 -0.001 0.000 0.000 -0.000
(0.432) (0.471) (0.331) (0.993) (0.949)
Gap 0.002 -0.001 0.001 0.001 0.000
(0.203) (0.693) (0.259) (0.620) (0.876)
Economic Controls Opentrade 0.000 0.000 -0.000 -0.000 0.000
(0.380) (0.143) (0.733) (0.749) (0.280)
Crises -0.004 -0.016 -0.005 -0.004 -0.005
(0.702) (0.351) (0.713) (0.784) (0.746)
Income -0.013*** -0.005 -0.006 0.001 -0.018***
(0.000) (0.642) (0.141) (0.880) (0.000)
Constant 0.233*** 0.263** 0.161*** 0.125*** 0.190***
(0.000) (0.025) (0.000) (0.001) (0.000)
R-squared 0.680 0.732 0.528 0.481 0.710
Note: See Table 2

42
Table A4.7: Political and economic determinants of financial openness (1980-2008)

FINOPEN Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep 0.009 0.021 0.006 0.090*** 0.095***
(0.567) (0.499) (0.772) (0.000) (0.000)
Exrate -0.019** 0.006 -0.022* -0.030** 0.019
(0.039) (0.796) (0.052) (0.020) (0.153)
Openfinancel 0.948*** 0.901*** 0.960*** 0.845*** 0.798***
(0.000) (0.000) (0.000) (0.000) (0.000)
Ideology Leftgov -0.001 0.006 -0.005 -0.004 -0.005
(0.858) (0.412) (0.442) (0.490) (0.449)
Leftgov*gap -0.001 0.004 -0.001 -0.000 -0.003
(0.713) (0.252) (0.549) (0.794) (0.229)
Political Controls Polconstrain 0.015 -0.003 0.011 0.016 -0.014
(0.169) (0.906) (0.397) (0.234) (0.391)
Incumbency -0.001 -0.002 -0.001 -0.001 0.001
(0.463) (0.484) (0.594) (0.579) (0.513)
Economic Targets Inflation -0.054*** -0.286*** -0.028 -0.062*** -0.002
(0.001) (0.000) (0.148) (0.001) (0.971)
Accountbal -0.000* 0.001 -0.000** -0.000 -0.000
(0.065) (0.183) (0.026) (0.384) (0.795)
Gap 0.001 -0.004** 0.002** 0.001 0.002*
(0.142) (0.018) (0.025) (0.515) (0.068)
Economic Controls Opentrade 0.000* 0.000 0.000 0.000*** -0.000
(0.089) (0.237) (0.637) (0.001) (0.144)
Crises -0.010 -0.029*** -0.004 -0.012 0.004
(0.161) (0.007) (0.644) (0.146) (0.661)
Income 0.008*** -0.007 0.010*** 0.005** 0.011***
(0.000) (0.298) (0.000) (0.020) (0.000)
Constant -0.024 0.161** -0.035 -0.033 0.062**
(0.227) (0.023) (0.141) (0.167) (0.035)
R-squared 0.940 0.938 0.921 0.776 0.866
Note: See Table 2

43
Table A4.8: Political and economic determinants of financial openness (1990-2010)

FINOPEN Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep 0.013 0.049 0.002 0.091*** 0.090***
(0.447) (0.117) (0.921) (0.003) (0.000)
Exrate -0.006 0.046** -0.011 -0.021 0.031***
(0.545) (0.026) (0.395) (0.192) (0.008)
Openfinancel 0.940*** 0.866*** 0.955*** 0.845*** 0.777***
(0.000) (0.000) (0.000) (0.000) (0.000)
Ideology Leftgov 0.001 0.010 -0.006 0.001 -0.003
(0.868) (0.187) (0.406) (0.854) (0.570)
Leftgov*gap -0.002 -0.002 -0.001 -0.002 -0.004*
(0.305) (0.515) (0.635) (0.442) (0.062)
Political Controls Polconstrain 0.011 -0.023 0.006 0.009 0.014
(0.369) (0.402) (0.693) (0.585) (0.371)
Incumbency -0.001 -0.002 -0.001 -0.002 0.002
(0.434) (0.337) (0.629) (0.316) (0.206)
Economic Targets Inflation -0.002 -0.334*** 0.023 -0.025 0.027
(0.929) (0.000) (0.354) (0.343) (0.583)
Accountbal -0.000* 0.001* -0.000* -0.000 0.000
(0.073) (0.073) (0.060) (0.266) (0.403)
Gap 0.002** -0.002 0.003*** 0.001 0.002**
(0.022) (0.225) (0.004) (0.222) (0.012)
Economic Controls Opentrade 0.000 0.000 -0.000 0.000 -0.000**
(0.716) (0.825) (0.578) (0.173) (0.030)
Crises -0.005 -0.020** -0.002 -0.005 -0.000
(0.468) (0.034) (0.867) (0.653) (0.985)
Income 0.012*** -0.003 0.012*** 0.007** 0.011***
(0.000) (0.716) (0.000) (0.012) (0.000)
Constant -0.054** 0.139* -0.051* -0.049 0.063**
(0.017) (0.070) (0.061) (0.111) (0.032)
R-squared 0.940 0.926 0.921 0.765 0.862
Note: See Table 2

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Table A4.9: Political and economic determinants of financial openness (1990-2008)

FINOPEN Full Sample OECD Non-OECD Closed Open

Trilemma MonIndep 0.010 0.052 -0.003 0.084*** 0.100***
(0.576) (0.130) (0.889) (0.010) (0.000)
Exrate -0.013 0.044* -0.018 -0.028* 0.032**
(0.235) (0.060) (0.178) (0.099) (0.015)
Openfinancel 0.937*** 0.864*** 0.952*** 0.854*** 0.762***
(0.000) (0.000) (0.000) (0.000) (0.000)
Ideology Leftgov 0.000 0.012 -0.009 -0.001 0.003
(0.999) (0.149) (0.257) (0.943) (0.670)
Leftgov*gap -0.002 -0.004 -0.000 -0.002 -0.006**
(0.313) (0.327) (0.852) (0.396) (0.016)
Political Controls Polconstrain 0.012 -0.034 0.009 0.011 0.018
(0.348) (0.257) (0.564) (0.508) (0.320)
Incumbency -0.002 -0.003 -0.001 -0.002 0.002
(0.328) (0.312) (0.517) (0.248) (0.217)
Economic Targets Inflation -0.020 -0.374*** 0.004 -0.037 -0.011
(0.378) (0.000) (0.879) (0.168) (0.834)
Accountbal -0.000* 0.002** -0.001** -0.000 0.000
(0.067) (0.032) (0.034) (0.313) (0.509)
Gap 0.001 -0.004* 0.002* 0.001 0.002*
(0.142) (0.079) (0.054) (0.395) (0.058)
Economic Controls Opentrade 0.000 0.000 -0.000 0.000** -0.000*
(0.376) (0.495) (0.683) (0.032) (0.064)
Crises -0.007 -0.023* -0.003 -0.006 -0.005
(0.386) (0.052) (0.782) (0.578) (0.627)
Income 0.011*** -0.008 0.013*** 0.007** 0.011***
(0.000) (0.332) (0.000) (0.020) (0.000)
Constant -0.040* 0.199** -0.046 -0.041 0.080**
(0.093) (0.019) (0.104) (0.195) (0.011)
R-squared 0.937 0.924 0.917 0.765 0.856
Note: See Table 2

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Appendix A5: Histograms of dependent variables

Histogram of exchange rate stability Histogram of monetary independence

600

600
400

400
200

200
0

0
0 .2 .4 .6 .8 1 0 .2 .4 .6 .8 1
Exchange rate stability Monetary independence

Histogram of freedom of capital flows

600
400
200
0

0 .2 .4 .6 .8 1
Freedom of capital flows

Appendix A6: Marginal effects plots for fixed effects regressions

Marginal effect on 'exrate' (FE) Marginal effect on 'exrate', OECD sample (FE)
Percentage of observations of 'gap'
.1

15
% of observations of 'gap'

15
.1
10

10
0

0
5

5
-.1
-.1

-10 0 10 -10 0 10
Output gap Output gap

Marginal effect on 'monindep' (FE) Marginal effect on 'monindep', OECD sample (FE)
.1
.1

15
% of observations of 'gap'

% of observations of 'gap'

15
10

10
0
0

5
-.1
-.1

-10 0 10 -10 0 10
Output gap Output gap

46
Highlights

· We reconsiders the policy trilemma in an open economy

· We consider a sample of 124 countries from 1980 to 2014
· We emphasize the joint determination of the impossible trinity variables
· We find ideology effects to be most important in the context of exchange rate
policy

47