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:
- Setting a fixed currency exchange rate
- Allowing capital to flow freely with no fixed currency exchange
rate agreement
- 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 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.