Foreign exchange reserves, imperfect substitutability of financial assets and the monetary policy quadrilemma

By Thibault Laurentjoye

PKES Working Paper 2222

October 2022

In this paper, I investigate how the use of foreign exchange reserves can turn the monetary policy trilemma into a quadrilemma. After surveying recent developments in international macroeconomics literature, including the dilemma vs trilemma debate and the dominant currency paradigm, I make a twofold contribution to support the case for the quadrilemma. The first contribution is a logical characterisation of the quadrilemma in the form of a single equation which includes exchange rate variations, interest rate differential, capital controls and the level of reserves. The second contribution consists of a nominal stock-flow consistent model with two countries, characterised by perfect capital mobility and imperfect asset substitutability, to study the pure effect of international investors’ portfolio reallocation following unanticipated changes in the policy rate of the domestic economy. The model is run several times, varying the direction of the monetary policy shock and the relative size of the two countries. Two constraints on reserves are highlighted, one in the short run and one in the long run – albeit less significant – which define the limit between the classical trilemma and the quadrilemma.

Keywords: International reserves, foreign exchange intervention, monetary policy trilemma, quadrilemma, stock-flow consistent modelling

JEL classification: E43 E58 F31 F32 F36 F41