Question

What is meant by the Incompatible Trinity? Illustrate your answer with an example of a fixed currency exchange regime and an example of a floating currency exchange regimeWhat is meant by the Incompatible Trinity? Illustrate your answer with an example of a fixed currency exchange regime and an example of a floating currency exchange regime

Answer 1

The trinity that is said to be incompatible is constituted by fixed exchange rate, independent monetary policy and free capital mobility. For any economy, it is impossible to achieve all the three objectives of the trinity and it can be understood by the perspective of fixed and floating exchange rate. When a country wants to maintain a fixed exchange rate, and let free capital flow to and from the economy, then it will put pressure upon the exchange rate value. It will either appreciate or depreciate depending upon the economic conditions. But, government has to make stable and fixed exchange rate, then monetary policy will be manipulated and central bank will be asked to either sell or buy the foreign currency. It will make monetary policy to lose its autonomy.

In a different perspective, if monetary policy, is autonomous as one part of trinity and free capital flow is there as a second part of trinity, then capital can come in or go out of the country, depending upon the interest rate in economy and in the world. It will either depreciate or appreciate the domestic currency and free exchange rate will be converted into a floating exchange rate. So, again the trinity is not achieved. It is the reason that makes trinity to be incompatible.