FOUR International Macroeconomic Policy The Monetary Trilemma for rate stability
ID: 1096857 • Letter: F
Question
FOUR International Macroeconomic Policy The Monetary Trilemma for rate stability Open Economies The vertices of the triangle show three features that policy makers in open economies would prefer their monetary system to achieve. Unfortunately, at most two can coexist. Each of the three policy regime labels along the triangle's edges (floating exchange rate, fixed exchange rate, financial controls) is consistent with the two goals that it lies between in the diagram. simultaneously. Each edge of the triangle represents a policy regime consistent the two properties shown at the edge's end points. Of course, the trilemma does not imply that intermediate regimes are impos I Internal Balance (II), External Balance (XX), and the Four Zones of Economic Discomfort The diagram shows what different levels of the exchange rate, E, and overall domestic spending, A imply for employment and the current account. Along II, output A at its full employment keel. Along XX, the current account is at its target level, X.Explanation / Answer
Triffen Trilemma represents the inconsistency in policy regime, among financial controls, fixed exchange rate, and floating exchange rate. A monetary authority has the option to choose the policies on either of two corners, and has to give the policy on the opposite corner.
The graph in figure 19-2 could only be explained under floating exchange rate with monetary policy autonomy, because under the fixed exchange rate, the rate will be remain at 1, and would not cause as described in the diagram. Under fixed exchange rate, output will be at full employment, balance of payment will be at equilibrium and exchange rate will be at natural rate in the long-run. *there could be short run change but in the long-run all the variables settle down.
To understand the dynamics, assume that the economy is at equilibrium, with full employment, and output is at natural level.
Consider Zone 1. In zone 1, exchange rate is higher than the equilibrium level, as a result, the currency will deprecate in the international market. The depreciation of currency will make home goods and services cheap in the international market. Thus, net export increases (that is, surplus current account). On the other hand, the excess of export means excess demand from outside world; hence employment as well as income will also increase above potential level.
Consider Zone 2. In zone 1, exchange rate will be different from market clearing (C=X), since, the real output afford to go above Y=Y’, therefore there will appreciation of currency in the international market. The appreciation of currency will make home goods and services costlier in the international market. Thus, net export will fall (that is, deficit current account). On the other hand, due to excess of demand the firms will hire more, as a result the employment will increase.
Consider Zone 3. In zone 3, the domestic spending is less market clearing aggregate demand, Y=Y’ and exchange rate less than market clearing rate. When domestic spending is less, deflationary impact will cause producers to scale down the production; hence the problem of underemployment will rise. On the other hand, the exchange rate is on the right hand side of the market clearing rate (CA=X), and it is lower than at 1, there will be excess of import, which will result into current account deficit.
Consider Zone 4. In zone 4, the domestic spending is less but exchange rate can be high or low. When domestic spending is less, deflationary impact will cause producers to scale down the production; hence the problem of underemployment will rise. On the other hand, the exchange rate in shaded region is on the left hand side of the market clearing rate (CA=X), the net export will increase, and there will be excess of current account surplus.
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