“The Open Policy Trinity may not be a Trilemma in Reality: A perspective from an interest rate band hypothesis”

Helen Huixian Zhang, University of Auckland

The open policy trilemma states that monetary independence, a fixed exchange rate regime, and an open capital market cannot be achieved simultaneously. However, as a cornerstone of the trilemma, the uncovered interest rate parity (UIP) is universally rejected in empirical research, especially in the short run. Hence, this paper argues that interest rates across countries are not necessarily in parity because unavoidable arbitrage costs will leave a gap between different interest rates as a non-profit arbitrage band for arbitrageurs. The interest rate gap caused by arbitrage costs would give leeway to monetary policy even combined with a fixed exchange rate regime and an open capital market. Therefore, by proposing an interest rate band hypothesis, this paper aims to theoretically and empirically demonstrate that the open policy trinity might not be a trilemma in reality.  This demonstration might shed light on the monetary policy of central banks and a reconstruction of the international financial architecture.