Question

Explain the nature of the macroeconomic `trilemma.’ Why is the trilemma inescapable, and how have countries tended to deal with it over time?

Answer 1

There are three policy objectives in international economic perspective that are fixed exchange rates, independent monetary policy and free capital flows. These three objectives are referred as macroeconomic trilemma because only two of the three objectives can be achieved at a time and all three objective cannot be achieved. So, it is named as macroeconomic trilemma.
The trilemma is inescapable and it can be understood by the following examples:
1.   If a country want a free flow of capital and independent monetary policy keeps interest rates that are different to the interest rate in world market or other countries, then it will cause inflow or outflow of the capital, depending upon the domestic interest rate in comparison to the interest rates in other markets. It will bring fluctuation in the exchange rate and it will not remain fixed. It means that fulfilling the objective of free flow of capital and independent monetary policy, will make it impossible to achieve the objective of fixed exchange rates.
2.   If a country wants independent monetary policy and fixed exchange rates and keeps changing the interest rates that are different to the interest rates in other countries, then it will force the movement of capital flows. Since, the objective is to keep the exchange rate fixed or stable, then capital flow will be controlled. So, the objective of free capital flow will not be achieved when objective of independent monetary policy and fixed exchange rates is pursued.

Countries over a period of time pick two of the objectives that are most important to them try to fulfill their macroeconomic goals. These two objectives can keep changing over a period of time. For example, any country who is opening up to the globalization and international trade, will go for stable exchange rate and independent monetary policy. While doing so, capital flow will be regulated to stabilize the economy when it grows fast due to trade liberalization. Once all the dimensions of the economic policies, institutions, regulatory mechanism are set up, the country can choose to go with fixed exchange rate and free capital flows so that economy can absorb the volatility and remain stable.