Question

Explain the so-called impossible trinity (also known as open economy trilemma). Using the diagram, discuss the policy alternatives of the monetary authority under different scenarios

Answer 1

Answer -

Before understanding Economic Trilemma, we have to understand the concept of Trilemma. It is a term in economic decision-making theory. Unlike a dilemma, which has two solutions, a trilemma offers three equal solutions to a complex problem.

A trilemma suggests that countries will have three options from which to choose when making fundamental decisions about managing their international monetary policy agreements. However, the options of the trilemma are conflictual because of mutual exclusivity, which makes only one option of the trilemma achievable at a given time.

Trilemma often is synonymous with the "impossible trinity," also called the Mundell-Fleming trilemma. This theory exposes the instability inherent in using the three primary options available to a country when establishing and monitoring its international monetary policy agreements.

The Impossible Trinity (Economic Trilemma) is an important concept in international economics which was developed independently by both Fleming and Mundell. It states that it is virtualy impossible to have all of the following three at the same time and governments that have tried to simultaneously pursue all three goals have failed..

• Fixed Foreign Exchange Rate
• Free Capital Movement with no fixed currency exchange rate agreement (i.e absence of capital controls)
• an independent/ autonomous monetary policy

  

The above diagram shows "The Impossible Trinity or "The Economic Trilemma", in which only two policy positions are possible at a given point of time. For example, If a nation were to adopt position "a", then it would maintain a fixed exchange rate and allow free capital flows, the consequence of the same would be loss of monetary sovereignty /Independence. Now we shall discuss each type of policy alternatives available to the monetary authority under different scenarios with the help of above diagram ..

• Side A of Triangle : A country can choose to fix exchange rates with one or more countries and have a free flow of capital with others. If it chooses this scenario, independent monetary policy is not achievable because interest rate fluctuations would create currency arbitrage stressing the currency pegs and causing them to break.
• Side B of Triangle : The country can choose to have a free flow of capital among all foreign nations and also have an autonomous monetary policy. Fixed exchange rates among all nations and the free flow of capital are mutually exclusive. As a result, only one can be chosen at a time. So, if there is a free flow of capital among all nations, there cannot be fixed exchange rates.
• Side C of Triangle : If a country chooses fixed exchange rates and independent monetary policy it cannot have a free flow of capital. Again, in this instance, fixed exchange rates and the free flow of capital are mutually exclusive.

However, generally, most of the countries favor side B of the triangle because they can enjoy the freedom of independent monetary policy and at the same time, allow the policy to help guide the flow of capital.

Policy Choices

If we assume that world interest rate is at 5% and the home central bank tries to set domestic interest rate at a rate lower than 5%, for example at 2%, there will be a depreciation pressure on the home currency, because investors would want to sell their low yielding domestic currency and buy higher yielding foreign currency. If the central bank also wants to have free capital flows, the only way the central bank could prevent depreciation of the home currency is to sell its foreign currency reserves. Since foreign currency reserves of a central bank are limited, once the reserves are depleted, the domestic currency will depreciate.

Hence, all three of the policy objectives mentioned above cannot be pursued simultaneously. A central bank has to forgo one of the three objectives. Therefore, a central bank has three policy combination options.

Available Options / Policy Alternatives

In terms of the diagram above, the available options are:

• Option (a): A stable exchange rate and free capital flows (but not an independent monetary policy because setting a domestic interest rate that is different from the world interest rate would undermine a stable exchange rate due to appreciation or depreciation pressure on the domestic currency).
• Option (b): An independent monetary policy and free capital flows (but not a stable exchange rate).
• Option (c): A stable exchange rate and independent monetary policy (but no free capital flows, which would require the use of capital controls).

Capital controls are residency-based measures such as transaction taxes etc. that a nation's government can use to regulate flows from capital markets into and out of the country's capital account. These measures may be economy-wide, sector-specific or industry specific. Further they may apply to all flows, or may differentiate by type or duration of the flow (debt, equity, direct investment; short-term vs. medium- and long-term).

Types of capital control include exchange controls that prevent or limit the buying and selling of a national currency at the market rate, caps on the allowed volume for the international sale or purchase of various financial assets, minimum stay requirements, requirements for mandatory approval, or even limits on the amount of money a private citizen is allowed to remove from the country.

A fixed exchange rate/ pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or gold. In a fixed exchange rate system, a country’s central bank typically uses an open market mechanism and is committed at all times to buy and/or sell its currency at a fixed price in order to maintain its pegged ratio and, hence, the stable value of its currency in relation to the reference to which it is pegged. To maintain a desired exchange rate, the central bank during a time of private sector net demand for the foreign currency, sells foreign currency from its reserves and buys back the domestic money. This creates an artificial demand for the domestic money, which increases its exchange rate value. Conversely, in the case of an incipient appreciation of the domestic money, the central bank buys back the foreign money and thus adds domestic money into the market, thereby maintaining market equilibrium at the intended fixed value of the exchange rate.

A floating exchange rate /fluctuating or flexible exchange rate is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange market events. A currency that uses a floating exchange rate is known as a floating currency. A floating currency is contrasted with a fixed currency whose value is tied to that of another currency, material goods or to a currency basket.

Monetary sovereignty is the power of the nation to exercise exclusive legal control over its currency, i.e Legal tender – the exclusive authority to designate the legal tender forms of payment. Monetary autonomy refers to the independence of a country's central bank to affect its own money supply and conditions in its domestic economy. In a floating exchange rate system, a central bank is free to control the money supply.

Thus, Trilemma / "impossible trinity" (Mundell-Fleming trilemma), theory exposes the instability inherent in using the three primary options available to a country when establishing and monitoring its international monetary policy agreements. The Unholy Trinity is an international economic principle which suggests that the policymakers of a country may pursue only two out of three policy directions. The three policy directions are the free movement of capital, an independent monetary policy, and a fixed or pegged exchange rate policy