Question

Drawing on your knowledge of the balance of payments so far, explain how the three elements of The Impossible Trinity will both affect and are affected by a country’s balance of payments. Use 3 specific examples to illustrate your reasoning.

Answer 1

Three elements of the impossible trinity or the trilemma are:

1) a fixed foreign exchange rate

2) free capital movement

3) an independent monetary policy

And the Impossible Trinity will both affect & are affected by a country’s balance of payments (BOP). So the balance of payment can be defined as the summary of all the transactions between a country's residents with foreign country which involve goods, services, income, financial claims on and liabilities It also includes the transfers such as gifts.

So, let us try to understand this relationship between trinity and the BOP through some examples.

1.Exchange Rate- Suppose the country has fixed foreign exchange rate, then the BOP will suffer as the exchange rate will be exogenous and the balance of payments surplus will be determined by the model which cannot be altered which leads to inflexibility in transactions.

2. Global interest rate – Suppose the global interest rate increased then the BoP increases due to capital flows out of the local economy. This depreciates the local currency and boosts net exports leading to more transaction and BOP starts increasing.

3.Money supply- An increase in money supply will reduce the local interest rate relative to the global interest rate. Capital outflow will increase which will lead to an increase in the real exchange rate, ultimately shifting the IS curve right until interest rates equal global interest rates.