Economists sometimes refer to the attempt by countries to fix their exchange rates, control their money...

Economists sometimes refer to the attempt by countries to fix their exchange rates, control their money supplies, and operate with open capital accounts in their balance of payments (that is, to have no restrictions on capital movements) as the ‘impossible trinity’ of international macroeconomics. Based on what you have learned so far, would you agree that this combination of policies is impossible to achieve. Explain.

Expert Solution

The impossible trinity is also known as trilemma. It states that a country must choose between free capital mobility, exchange rate management, and an independent monetary policy. Only two of the three are possible. A country that wishes to fix the value of its currency and have interest rate policy which is free from outside factors cannot allow capital to flow freely across borders. This was China's trilemma.

Britain's trilemma implies that the exchange rate is fixed but the country is open to cross-border capital flows then it cannot have an independent monetary policy. Similarly, if a country wants to choose free capital mobility and monetary autonomy then it has to allow its currency to float.

The original concept of trilemma was coined in the 1960s during the Bretton Woods regime as a binary choice of two out of the three policy goals. However, in the 1990s and 2000s, the emerging and developing countries found that deeper financial integration comes from financial instability and sudden crises of capital inflow and outflows. These crises have been attributed to exchange rate instability in response to balance sheet exposure to external hard currency debt propagating to bank instability and crises. Resulting in fiscal dominance and reduction in scope of monetary policy.

Rahul Sunny answered 2 years ago

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