Can Institutions Explain the Causality Relationship between Trilemma Instability and Macroeconomic Volatility?

We examine the causality relationship between macroeconomic regime instability and GDP growth volatility, taking into account the institutional environment. Using data from 44 emerging and developing countries for the period 1996- 2010, we study the mutual effects between monetary, exchange rate and financial instabilities and macroeconomic volatility. We apply the dynamic panel Granger causality test (The Wald test) based on GMM estimations to explore the existence and the directions of causality between real and financial sectors. We find that Causality going from macroeconomic regime instability to real fluctuations exists; the effect of the trilemma policy mix instability on macroeconomic volatility is larger than the opposite effect; reserve accumulation is an important stabilizer of real and financial spheres and there is a bidirectional causality only between monetary instability and macroeconomic fluctuations. Taking into account the institutional environment, we include a vector of institutional interaction terms in the model. We find that the most institutional interaction terms enter negatively and insignificantly in the model, indicating not only the deficiency of developing countries institutions but also the alleviating effect which can be exerted by institutions on the real and financial instabilities when they are integrated into a good institutional environment; and greater institutional performance is associated with lower volatile effects of real and financial spheres.