The impossible trinity (also called the trilemma) of international macroeconomic
ID: 1126834 • Letter: T
Question
The impossible trinity (also called the trilemma) of international macroeconomics holds that a country cannot simultaneously have (1) stable exchange rates, (2) exercise an independent monetary policy, and (3) maintain open capital flows. Explain why it is impossible to maintain all three of these policies at once.The impossible trinity (also called the trilemma) of international macroeconomics holds that a country cannot simultaneously have (1) stable exchange rates, (2) exercise an independent monetary policy, and (3) maintain open capital flows. Explain why it is impossible to maintain all three of these policies at once.
Explanation / Answer
The currencies are bought and sold in the foreign exchange market. The equilibrium price of foreign currency is determined through the demand and supply of home currency in the exchange market. The equilibrium price of a currency is called the fundamental value of a currency.
The exchange rate is the price of foreign currency in terms of home currency. There are two exchange rate: fixed and flexible. The fixed exchange rate is determined by the government of the country and the flexible exchange rate is determined by the demand and supply in foreign exchange market.
In fixed exchange rate regime if the value of currency fixed by the government is below the fundamental value of a currency then it is said to be undervalued. If the value of currency fixed by the government is above the fundamental value of a currency then it is said to be overvalued.
The overvalued exchange rate is the value of fixed exchange rate that is set over the fundamental value of the currency determined in the foreign exchange market. The government can response to an overvaluation of exchange rate by adopting four following policies:
Therefore, to maintain the fixed exchange rate ragime the government has to restrict capital flow and has to engage in open market operation to control money supply in the foreign exchange market. In case of fixed exchange rate the ability of monetary policy is limited. If the government uses the monetary policy to maintain the fundamental exchange rate at official exchange rate, it cannot use it to stabilize the economy.
Hence, the country cannot simultaneously have (1) stable exchange rates, (2) exercise an independent monetary policy, and (3) maintain open capital flows.
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