Impossible Trinity in a Small Open Economy: A State–Space Model Simulation

Should monetary policy independence be maintained when the exchange rate is fixed under closed capital account conditions in a small open economy? In this study, we simulate impossible trinity condition during 1989 to 2019 on Nepalese economy that restricts flows and fixes with India. We modify traditional Taylor rule based reaction function characterize Nepal's economic more closely. The state–space model simulation shows trilemma does not hold Nepal, such can predict interest weight for domestic assigned at substantially lower level. Therefore, existing mix may need revisited maintain independence. Nepal might consider devaluing its currency neutralize adverse effects of negative risk premium ameliorate real appreciation short run explore alternative arrangements long run.