Question

Discuss ways to use to support one’s currency if there is a financial/capital account deficit. What problems are there? What are the implications for monetary policy and freedom of capital movements? This, professor Kallianiotis calls the trilemma/impossible trinity and explains it. In other words, talk on freedom of capital movements, monetary policy and fixed exchange rates.

Answer 1

When the total expenditure of the government exceeds the total revenue a fiscal deficit is said to occur on the other hand when the total value of the goods and services a country imports exceeds the total value of the goods and services it exports a current account deficit is said to occur.

We can adopt the following measures to solve the problem of a current account deficit-

• Devaluation of interest rates- this makes exports cheaper and imports more expensive and improves the position of the current account
• Reduce domestic consumption on imports by imposing high tariffs.
• Supply side policies like subsidies to local producers to increase competitiveness of domestic industries.
• Tightening of monetary policy- Higher interest rates will discourage consumption on imports as they will make cost of borrowing higher and reduce aggregate demand in the economy..
• Deflationary fiscal policy -Increasing taxes to reduce disposable income and hence spending on imports

The two basic methods to reduce fiscal deficit are-

• Cut government spending- Evaluating the various government departments and analysing where spending can be reduced is a good way to reduce fiscal deficit.
• Higher taxes increase revenue reduce the budget deficit. Like spending cuts, they could cause lower spending and lead to a fall in economic growth, Therefore their timing has to be given paramount importance.

According to the Trilemma model a choice has to be made between three options-

1) Setting a fixed exchange rate system

2) Allowing the free flow of capital with no exchange rate agreements

3) Independent monetary policy

This is referred to as a trilemma situation because the events are exclusive of each other and a conflict arises as only two goals are achievable at one time. This can be understood by considering  three scenarios-

1) If a country has free trade with another country and a fixed exchange rate system then it cannot achieve an independent monetary policy. This is because of fluctuations in interest rates which will encourage arbitrage which is bad for the country.

(Arbitrage- buying and selling securities in different markets to make money because of difference in prices

2) A country cannot have fixed exchange rates with all nations and a free flow of capital at the same time. The second combination is therefore of a fixed exchange rate system and an independent monetary policy.

3) An independent monetary policy and free flow of capital between nations.