Question

Explain the concept of “The Impossible Trinity”. Use the case of expansionary monetary policy to illustrate your answer. (20%)

Answer 1

Many economists think of possible policy responses to capital flows in terms of the so-called “impossible trinity,” or “policy trilemma”, according to which, with an open capital account, a central bank cannot simultaneously exercise monetary control and target the exchange rate.
This framework helps highlight the trade-offs faced by policymakers in small open economies
and what choices they have made in order to resolve them.
Indeed, a review of monetary frameworks around the world suggests that over the past two
decades or more, many countries have concluded that the best way to resolve the
impossible trinity is by seeking to maintain open capital accounts, and then allowing the
exchange rate to float so as to exercise domestic monetary control – often in an inflation
targeting framework. The countries represented in this panel are prominent examples.
In practice, however, the choices made by policymakers are not so clear-cut. I will illustrate
this by discussing:
the implications of central bank intervention in foreign exchange markets under floating exchange rate regimes;
much more briefly, the fact that floating might not give as much monetary policy independence as one might have expected; and
renewed interest in capital controls.

There are several actions that a central bank can take that are expansionary monetary policies. Monetary policies are actions taken to affect the economy of a country. The key steps used by a central bank to expand the economy include:

• Decreasing the discount rate.
• Purchasing government securities.
• Reducing the reserve ratio.

  The most widely recognized successful implementation of monetary policy in the U.S. occurred in 1982 during the anti-inflationary recession caused by the Federal Reserve under the guidance of Paul Volcker.

  The U.S. economy of the late 1970s was experiencing rising inflation and rising unemployment. This phenomenon, called stagflation, had been previously considered impossible under Keynesian economic theory and the now-defunct Phillips Curve. By 1978, Volcker worried that the Federal Reserve was keeping the interest rates too low and had them raised to 9%. Still, inflation persisted.