Abstract: With the deepening of global financial integration, more and more new factors are influencing the effectiveness of monetary policies, resulting in questions on the usefulness of the analytical framework of “Impossible Trinity”. Recently, some scholars proposed a new analytical framework of “Dilemma” which argues that as long as a country allows free capital flows, its monetary policy would not be effective and independent, no matter it adopts a floating or fixed exchange rate regime. In this study, we revise the Mundell-Fleming model by including features of global financial integration. Based on this new model, we look into the following hypothesis: an increase of global risk aversion can reduce the effectiveness of monetary policy. We find that when the increase in domestic risk premium caused by global risk aversion exceeds the impact of monetary easing, monetary policy can become ineffective. Our empirical model based on panel data analysis strongly supports this hypothesis.

Full report ：WP No.20168 Global Risk Aversion and Capital Flows——An Explanation of “Impossible Duality”.pdf