Impossible trinity

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Not to be confused with impossible triangle.

The Impossible Trinity or "The Trilemma", in which three policy positions are possible. If a nation were to
adopt positiona, for example, then it would maintain a fixed exchange rate and allow free capital flows, the
consequence of which would be loss of monetary sovereignty.

The Impossible trinity (also known as the Trilemma) is a trilemma in international economics which
states that it is impossible to have all three of the following at the same time:

A stable foreign exchange rate

Free capital movement (absence of capital controls)

An independent monetary policy

It is both a hypothesis based on the uncovered interest rate parity condition, and a finding from
empirical studies where governments that have tried to simultaneously pursue all three goals have
failed.

Policy choices[edit]
According to the impossible trinity, a central bank can only pursue two of the above-mentioned three
policies simultaneously. To see why, consider this example:
Assume that world interest rate is at 5%. If the home central bank tries to set domestic interest rate
at a rate lower than 5%, for example at 2%, there will be a depreciation pressure on the home
currency, because investors would want to sell their low yielding domestic currency and buy higher
yielding foreign currency. If the central bank also wants to have free capital flows, the only way the
central bank could prevent depreciation of the home currency is to sell its foreign currency reserves.
Since foreign currency reserves of a central bank is limited, once the reserves are depleted, the
domestic currency will depreciate.
Hence, all three of the policy objectives mentioned above cannot be pursued simultaneously. A
central bank has to forgo one of the three objectives. Therefore a central bank has three policy
combination options.
a) Stable Exchange Rate and Free Capital Flow
b) Independent Monetary Policy and Free Capital Flow
c) Stable Exchange Rate and Independent Monetary Policy

Theoretical derivation[edit]
The formal model underlying the hypothesis is the uncovered Interest Rate Parity
condition which states that in absence of a risk premium, arbitrage will ensure that the
depreciation or appreciation of a country's currency vis--vis another will be equal to
the nominal interest rate differential between them. Since under a peg, the exchange
rate cannot change, short of devaluation or abandonment of the peg, this means that
the two countries' nominal interest rates have to be equalized.
This in turn implies that the pegging country has no ability to set its nominal interest rate
independently, and hence no independent monetary policy. The only way then that the

country could have both a fixed exchange rate and an independent monetary policy is if
it can prevent arbitrage in the foreign exchange rate market from taking place - institutes
capital controls on international transactions.

Trilemma in practice[edit]
The idea of the impossible trinity went from theoretical curiosity to becoming the
foundation of open economy macroeconomics in the 1980s, by which time capital
controls had broken down in many countries, and conflicts were visible between pegged
exchange rates and monetary policy autonomy. While one version of the impossible
trinity is focused on the extreme case with a perfectly fixed exchange rate and a
perfectly open capital account, a country has absolutely no autonomous monetary policy
the real world has thrown up repeated examples where the capital controls are
loosened, resulting in greater exchange rate rigidity and less monetary-policy autonomy.
In 1997, Maurice Obstfeld and Alan M. Taylor brought the term "trilemma" into
widespread use within economics.[1] In work with Jay Shambaugh, they developed the
first methods to empirically validate this central, yet hitherto untested, hypothesis in
international macroeconomics.[2]
Economists Michael C. Burda and Charles Wyplosz provide an illustration of what can
happen if a nation tries to pursue all three goals at once. To start with they posit a nation
with a fixed exchange rate at equilibrium with respect to capital flows as its monetary
policy is aligned with the international market. However, the nation then adopts an
expansionary monetary policy to try to stimulate its domestic economy.
This involves an increase of the monetary supply, and a fall of the domestically available
interest rate. Because the internationally available interest rate adjusted for foreign
exchange differences has not changed, market participants are able to make a profit by
borrowing in the country's currency and then lending abroad a form of Carry trade.
With no capital control market players will do this en masse. The trade will involve
selling the borrowed currency on the foreign exchange market in order to acquire foreign
currency to invest abroad this tends to cause the price of the nation's currency to drop
due to the sudden extra supply. Because the nation has a fixed exchange rate, it must
defend its currency and will sell its reserves to buy its currency back. But unless the
monetary policy is changed back, the international markets will invariably continue until
the government's foreign exchange reserves are exhausted, [3] causing the currency to
devalue, thus breaking one of the three goals and also enriching market players at the
expense of the government that tried to break the impossible trinity.[4]

Possibility of a dilemma[edit]
In the modern world, given the growth of trade in goods and services and the fast pace
of financial innovation, it is possible that capital controls can often be evaded. In
addition, capital controls introduce numerous distortions. Hence, there are few important
countries with an effective system of capital controls, though by early 2010 there has
been a movement among economists, policy makers and the International Monetary
Fund back in favour of limited use.[5][6][7] Lacking effective control on the free movement of
capital, the Impossible Trinity asserts that a country has to choose between reducing
currency volatility and running a stabilising monetary policy: it cannot do both. As stated
by Paul Krugman in 1999:[8]

The point is that you can't have it all: A country must pick

Impossible trinity and Historical events[edit]

The combination of the three policies, Fixed Exchange Rate and Free Capital Flow and
Independent Monetary Policy, is known to cause financial crisis. The Mexican peso
crisis(199495), the 1997 Asian financial crisis (199798), and the Argentinean financial
collapse (200102)[10] are often cited as examples.
In particular, the East Asian crisis (199798) is widely known as a large-scale financial
crisis caused by the combination of the three policies which violate the impossible trinity.
[11]
The East Asian countries were taking a de facto dollar peg (fixed exchange rate),
[12]
promoting the free movement of capital (free capital flow)[11] and making independent
monetary policy at the same time. First, because of the de facto dollar peg, foreign
investors could invest in Asian countries without the risk of exchange rate fluctuation.
Second, the free flow of capital kept foreign investment uninhibited. Third, the short-term
interest rates of Asian countries were higher than the short-term interest rate of the
United States from 1990-99. For these reasons, many foreign investors invested
enormous amounts of money in Asian countries and reaped huge profits. While the
Asian countries' trade balance was favorable, the investment was pro-cyclical for the
countries. But when the Asian countries' trade balance shifted, investors quickly
retrieved their money, triggering the Asian crisis.