Question

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

Answer 1

The impossible trinity (also known as the trilemma, or the unholy trinity or Mundell-Fleming trilemma) expresses the limited options available to countries in setting monetary policy. According to this theory, a country cannot achieve the free flow of capital, a fixed exchange rate and independent monetary policy simultaneously. By pursuing any two of these options, it necessarily closes off the third.

We cas say that it 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.

History has shown that different international financial systems have attempted to achieve combinations of two out of the three policy goals, such as the Gold Standard system – guaranteeing capital mobility and exchange rate stability – and the Bretton Woods system – providing monetary autonomy and exchange rate stability. The fact that economies have altered the combinations as a reaction to crises or major economic events may be taken to imply that each of the three policy options is a mixed bag of both merits and demerits for managing macroeconomic conditions. Greater monetary independence could allow policy makers to stabilize the economy through monetary policy without being subject to other economies’ macroeconomic management, thus potentially leading to stable and sustainable economic growth. However, in a world with price and wage rigidities, policy makers could also manipulate output movement (at least in the short-run), thus leading to increasing output and inflation volatility. Furthermore, monetary authorities could also abuse their autonomy to monetize fiscal debt, and therefore end up destabilizing the economy through high and volatile inflation.

Exchange rate stability could bring out price stability by providing an anchor, and lower risk premium by mitigating uncertainty, thereby fostering investment and international trade. Also, at the time of an economic crisis, maintaining a pegged exchange rate could increase the credibility of policy makers and thereby contribute to stabilizing output movement (Aizenman and Glick, 2009). However, greater levels of exchange rate stability could also rid policy makers of a policy choice of using exchange rate as a tool to absorb external shocks.1 Hence, the rigidity caused by exchange rate stability could not only enhance output volatility, but also cause misallocation of resources and unbalanced, unsustainable growth. Financial liberalization is perhaps the most contentious and hotly debated policy among the three policy choices of the trilemma. On the one hand, more open financial markets could lead to economic growth by paving the way for more efficient resource allocation, mitigating information asymmetry, enhancing and/or supplementing domestic savings, and helping transfer of technological or managerial know-how (i.e., growth in total factor productivity).2 Also, economies with greater access to international capital markets should be better able to stabilize themselves through risk sharing and portfolio diversification. On the other hand, it is also true that financial liberalization has often been blamed for economic instability, especially over the last two decades, including the current crisis. Based on this view, financial openness could expose economies to volatile cross-border capital flows resulting in sudden stops or reversal of capital flows, thereby making economies vulnerable to boom-bust cycles (Kaminsky and Schmukler, 2002).

According to survey, global capital market integration has followed a U-shaped pattern since the outbreak of World War I. Integration peaked during the classical gold standard period, declined during the inter-war period, only to recover during Bretton Woods. survayer note that market integration has increased dramatically in the last twenty years.