Question

Explain the open economy policy trilemma.

Answer 1

The impossible trinity (also known as the trilemma, or the unholy trinity) is a concept in international economicswhich states that it is impossible to have all three of the following at the same time:

• a fixed foreign exchange rate
• free capital movement (absence of capital controls)
• an independent monetary policy

It is both a hypothesis based on the uncovered interest rate parity condition, and a finding from empirical studies where governments that have tried to simultaneously pursue all three goals have failed. Ref - Wiki.

According to the impossible trinity, a central bank can only pursue two of the above-mentioned three policies simultaneously. To see why, consider this example:

Assume that world interest rate is at 5%. If 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.