Impossible Trinity

Definition

The impossible trinity, also known as the trilemma, is a concept in international economics that states a country cannot simultaneously maintain a fixed exchange rate, an independent monetary policy, and free capital movement. It suggests that a country must choose any two of these three policy goals, but cannot have all three at the same time.

5 Must Know Facts For Your Next Test

1. The impossible trinity is a fundamental concept in open-economy macroeconomics that explains the trade-offs faced by policymakers in managing a country's exchange rate, monetary policy, and capital flows.
2. A country can only choose any two of the three policy goals, as maintaining all three simultaneously is not possible due to the inherent conflicts between them.
3. If a country chooses to maintain a fixed exchange rate and an independent monetary policy, it must forgo free capital movement and impose capital controls to prevent destabilizing capital flows.
4. If a country chooses to maintain free capital movement and an independent monetary policy, it must forgo a fixed exchange rate and allow its currency to float freely.
5. If a country chooses to maintain a fixed exchange rate and free capital movement, it must forgo an independent monetary policy and instead align its interest rates with the anchor currency.

Review Questions

• Explain how the impossible trinity concept relates to a country's exchange rate policies.
  • The impossible trinity states that a country cannot simultaneously maintain a fixed exchange rate, an independent monetary policy, and free capital movement. This means that a country must choose any two of these three policy goals, as maintaining all three is not possible. For example, if a country wants to maintain a fixed exchange rate and have an independent monetary policy, it must forgo free capital movement and impose capital controls to prevent destabilizing capital flows.
• Analyze the trade-offs a country faces when choosing between the three policy goals of the impossible trinity.
  • When a country chooses to maintain a fixed exchange rate, it must either forgo an independent monetary policy (and align its interest rates with the anchor currency) or free capital movement (by imposing capital controls). If a country chooses to maintain free capital movement and an independent monetary policy, it must forgo a fixed exchange rate and allow its currency to float freely. The choice a country makes depends on its economic priorities and the specific challenges it faces, such as the need to maintain price stability, promote economic growth, or manage external shocks.
• Evaluate how the impossible trinity concept can influence a country's policy decisions and the potential consequences of those decisions.
  • The impossible trinity concept is a crucial consideration for policymakers when formulating exchange rate, monetary, and capital account policies. The choice a country makes among the three policy goals can have significant implications for its economic stability, competitiveness, and vulnerability to external shocks. For example, a country that prioritizes a fixed exchange rate and free capital movement may have to sacrifice an independent monetary policy, which could limit its ability to respond to domestic economic conditions. Conversely, a country that chooses to maintain an independent monetary policy and free capital movement may experience greater exchange rate volatility, which could impact its trade and investment flows. Understanding the trade-offs and consequences of the impossible trinity is essential for policymakers to make informed decisions that align with their country's economic objectives.

Related terms

Fixed Exchange Rate: A fixed exchange rate is a regime where a currency's value is tied to another currency or a basket of currencies, and the exchange rate is maintained within a narrow band by the central bank through interventions in the foreign exchange market.

Independent Monetary Policy: Independent monetary policy refers to a country's ability to set its own interest rates and money supply without being constrained by external factors, such as the policies of other countries or the exchange rate.

Free Capital Movement: Free capital movement, or capital mobility, is the ability of individuals and businesses to freely move capital (such as investments, loans, and savings) across international borders without restrictions.