The Impossible Trinity: Inflation Targeting, Exchange Rate Management and Open Capital Accounts in Emerging Economies

This paper contributes to the debate on macroeconomic management and capital account

regulations in developing and emerging countries (DECs). It argues that the recommendation

by neoclassical economists and international financial institutions (IFIs) to combine an

inflation targeting regime with exchange rate management, whilst maintaining open capital

accounts, is both impossible and potentially counterproductive. This, it shows with extensive

semi-structured interviews with currency traders in Brazil and London, is due to the peculiar

way such a regime shapes central bank interventions in the money and foreign exchange

markets and the destabilising way these interventions interact with financial market

expectations. The interview results also demonstrate that the guidelines issued by IFIs

actually undermine, rather than aid, DEC central banks’ initial attempt to manage excessive

exchange rate movements. These results support the long-standing argument by heterodox

economists and critical international political economists that DECs need to make the

exchange rate an explicit instrument and goal of their macroeconomic policy and complement

it with comprehensive capital account regulations to reduce the destabilising impact of

international capital flows. The interview results also give some concrete suggestions on how

to do so.