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

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 trilemma is an economic theory, which posits that countries may choose from three options when making fundamental decisions about their international monetary policy agreements.
• However, only one option of the trilemma is achievable at a given time, as the three options of the trilemma are mutually exclusive.
• Today, most countries favor free flow of capital and autonomous monetary policy.

When making fundamental decisions about managing international monetary policy, a trilemma suggests that countries have three possible options from which to choose. According to the Mundell-Fleming trilemma model, these options include:

1. Setting a fixed currency exchange rate
2. Allowing capital to flow freely with no fixed currency exchange rate agreement
3. Autonomous monetary policy

The technicalities of each option conflict because of mutual exclusivity. As such, mutual exclusivity makes only one side of the trilemma triangle achievable at a given time.

• Side A: 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: 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: 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.

The challenge for a government’s international monetary policy comes in choosing which of these options to pursue and how to manage them. Generally, most countries favor side B of the triangle because they can enjoy the freedom of independent monetary policy and allow the policy to help guide the flow of capital