Question

What is the Trilemma? How does the Trilemma relate to the four periods of international market integration?

What so you mean by Capital Account Regulations? Why are emerging economies considering to have them? What would be your advice to these countries?

Answer both in 250 words each

Answer 1

1.) The trilemma is related to three aspects of an open economy namely Fixed exchange rate, Independent monetary policy and financial market openess (measure through capital flows). It states that a country/economy can not have all the mentioned features at the same time so it has to give up atleast one of the above to achieve rest of the two. This can be explained as follows:

Suppose the country chooses to have fixed exchange rate and Independent monetary policy. It is possible to maintain these two features only when Capital account flows are restricted because free movement of capital from one country to another change the value of currency in international market and the fixed exchange rate can not be maintained. So if the country choose Fixed exchange rate independent monetary policy, it can not choose free capital movements.

Now suppose that the country chooses to have independent monetary policy and financial market openess. It means that the country allows complete and free movement of capital in and out of the country. For such a country, exchange rate is determined in international market only. So in this case the country give up fixed exchange regime.

Finally if a country chooses to have free flow of capital and fixed exchange rate, then it has to make sure that the monetary policy is well coordinated with rest of the world. Any deviation of monetary flow will result in huge capital inflow/outflow resulting in unstable exchange rate. So in this case, the country gives up its independence to perform monetary policy to its domestic needs.

Countries have, over different time period, acknowledged the trilemma and the world regime has been established based on this basic idea:

• During the gold era, each country's currency was expressed in terms of fixed value of gold and the gold was common measure of the unit. This is a case of fixed exchange rate regime with limited independence on monetary policy. It is mainly bacause several countries coordinated their monetary policy to their trading partners.
• During the war period, as the expenses of war escalated and countries felt the need to print more money to finance their war expenses, the fixed gold values were abandoned and the countries allowed their currencies to float against each other with complete independence of monetary policy.
• As the WW2 got over it was decided that to bring the stability to international monetary system, countries must peg their currency to a common currency (which turned out to be USD). This was the beginning of Bretton woods system where each country pegged their currency to USD and maintained it there with virtually no control on their monetary policy.
• During early 1970's it became impossible for certain countries to maintain the fixed value of their currency. It lead to turbulence in their domestic monetary system and a need was felt to leave the currency on its international value. This was the beginning of era of free float of exchange rate with independent monetary policy and also free capital movements.

2.) Capital account regulations refer to those restrictions that are put on capital moving from one country to another. Some countries do not allow foreign capital to enter in their at market determined exchange rate (free movement). Authorities in these country put several monetary and non-monetary barriers on such movement of capital. Emerging economies advocate having these regulations for several reasons like:

• The financial markets in these countries may not be developed enough to smoothly handle huge amount of capital inflow/outflow.
• The domestic monetary system may be different from that of international system. So, complete independence of monetary policy is essential for them.
• Increases the volatiltiy in financial system and there may not be enough mechanisms to absorb these shocks. This may leave emerging countries vulnerable to factors that are external to their policy domain.

Note that these are genuine concerns to put capital account restrictions in these countries. But overtime, all these issues can be worked upon to integrate these economies to the global economy. It is beneficial because free capital mobility has benefits like:

1. Increase foreign funding reduces financial constraints.
2. Save the administrative cost of monitoring.
3. Ensures market discipline on these countries.

So the countries can gain from opening up their capital account by reducing funding gaps and reducing inefficiencies. Therefore, free capital mobility is advocated. However before that, certain conditions need to be fulfilled. These are:

• Well-developed and transparent financial system.
• Financial literacy among the masses
• More discipline in fiscal and monetary policy.

Once these conditions are in order, the country will be able to reduce its vulnerabilities to external sector and benefit from the foreign capital, measured in terms of higher investments in the country.