Our account of the evolution of capital mobility centers on the open-economy trilemma as a fundamental organizing concept. The exchange-rate regime is often seen as tightly constrained by the trilemma, which imposes a stark tradeoff among exchange stability, monetary independence, and capital-market openness. Yet the trilemma has not gone without challenge. Some (such as Calvo and Reinhart 2001, 2002) argue that under the modern float, monetary autonomy often is limited. Others (such as Bordo and Flandreau 2003), that even under the classical gold standard, domestic monetary autonomy was considerable. How binding has the trilemma been in practice? In this chapter, we pursue one approach to answering the question, based on asking how the comovement of national interest rates varies with the exchange-rate regime and the presence of capital controls.

There are few antecedents in the literature. The approach taken by Rose (1996) uses a classic monetary model of exchange rates to assess the trilemma. He noted that the quantity theory of money implies an exchange rate response to shocks to “fundamentals” such as money, output, and interest rates. He then tested how well the model fits the data (in the second moments) to see how exchange-rate flexibility is related to “monetary divergence” in two countries, with the optional addition of linear and interaction controls based on capital-mobility indices. His results were “somewhat favorable but surprisingly weak” (p. 926). Still, as many papers have pointed out, we are poorly equipped to identify monetary-policy shocks. Using monetary aggregates is dubious when one cannot easily distinguish between demand and supply shocks to money, and also when the stability of velocity has to be assumed.