Question

Read about the Mundell-Flemming trilemma. Among the three: free capital mobility, exchange-rate management and monetary autonomy, what are the two that mexico seeks to manage and why does it chose the two, instead of the third.

Answer 1

The Mundell Fleming trilemma is a concept in international economics which says that it is impossible to have free capital mobilty,fixed foreign exchange rate and an independent monetary policy at the same time. There is evidence that governments which tried to follow all the three goals have failed. An eg will clarify why governments cannot follow the three policies together.If the world interest rate is 5% and the domestic interest rate is fixed at 3%there will be depreciation of the home currency.This is because investors like to sell low return domestic currency and buy high return foreign currency.Suppose the central bank also wants to have free capital flows, the central bank can stop home currency depreciation by selling foreign currency reserves.But it is known that foreign currency reserves are less in a country . So when foreign reserves become less there will be depreciation of domestic currency.So the central bank cannot follow all the three .

Mexico follows independent monetary policy and free capital flows.But it does not follow stable exchange rate.All three cannot be followed at a time because of the reason explained in the example above.