The dilemma phenomenon, logistics for monetary independence policy and foreign exchange reserves

The development of financial integration makes a country’s economic links difficult. This is especially so for emerging market countries, which are more vulnerable to economic shocks. The objective of this paper is to explore whether the emerging market countries which adopt floating exchange rate system have realized, at the same time, in the aftermath of a crisis, free movement of capital flow and independence of monetary policy. This is done by introducing foreign exchange reserves into Mundell–Fleming model to do derivation. The approach is supported by empirical research based on 20 emerging countries including China, Brazil, Poland and South Africa and others. It was found that: (1) after the crisis, the emerging market countries that implemented floating exchange rate system did not achieve monetary policy independence. Rapid accumulation of foreign exchange reserves weakened the positive effect of the increase in money supply on output; (2) As a result of holding foreign exchange reserves, the independence of monetary policy in emerging market countries has been challenged, independently of the type of exchange rate system adopted, which proves the existence of dilemma phenomenon. Finally, this study puts forward policy recommendations on the exchange rate system and capital account convertibility for China.