BTL 798 - Impossible Trinity

 

The Banking Tutor’s Lessons

BTL 798                                                                   27-06-2025

Impossible Trinity

The Impossible Trinity, also known as the Policy Trilemma, is an economic concept stating that a country cannot simultaneously achieve three policy goals: a Fixed Exchange Rate, Free Capital Movement, and an Independent Monetary Policy. 

A Nation must choose two of these objectives, as pursuing all three leads to conflicts and makes the third unattainable. 

Fixed Exchange Rate: The government maintains a specific exchange rate for its currency against another currency or a basket of currencies. This provides stability for international trade and investment, but it limits the central bank's ability to control interest rates. 

Free Capital Movement: Capital (money) can flow freely into and out of the country without restrictions. This promotes investment and global financial integration, but it can make it difficult to maintain a fixed exchange rate. 

Independent Monetary Policy: The central bank can set interest rates and control the money supply to manage domestic economic conditions (e.g., inflation, unemployment). However, if capital is flowing freely, attempts to change interest rates can be offset by capital flows that push the exchange rate away from the desired level. 

Examples of how the trilemma plays out: 

Fixed Exchange Rate + Free Capital Movement: If a country wants to maintain a fixed exchange rate and allow free capital flows, it must give up control over its monetary policy. For instance, if the country raises interest rates to fight inflation, capital will flow in, increasing demand for the currency and pushing the exchange rate above the target. The central bank would then need to intervene by buying foreign currency and selling its own, effectively negating the interest rate hike. 

Independent Monetary Policy + Free Capital Movement: If a country wants to control interest rates and allow free capital flows, it must accept a floating exchange rate. For example, if the country lowers interest rates to stimulate the economy, capital will flow out, weakening the currency. This can lead to inflation as import prices rise. The exchange rate will adjust to reflect these changes, but the central bank cannot prevent it. 

In essence, the Impossible Trinity highlights the trade-offs that countries face when making choices about their monetary policy and exchange rate regimes. 

Sekhar Pariti

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