Economists like to juggle even the simplest economic issues. That’s why it is difficult to find an economist who does not talk in terms of “on the one hand...” and “...on the other”. Interestingly, there are certain economic ‘trilemmas’ that can’t be resolved even with two hands. One such ‘trilemma’—the impossible trinity—says it is impossible to hold three things with two hands. Economists Robert Mundell and Marcus Fleming developed this hypothesis through what is now known as the Mundell-Fleming model. Today, our friends Jinny and Johnny are discussing what kind of challenge the term impossible trinity talks about.
Shailaja and Manoj K Singh
Johnny: Recently, I heard one economist talk about how the theory of the impossible trinity poses a challenge for policymakers. What is so serious about impossible trinity?
Jinny: Well, the term impossible trinity talks about the problem of choice among three options at the same time. The three options are: a fixed exchange rate, free capital movement, and an independent monetary policy. The wisdom of impossible trinity says of these, you can choose any two at a time, at best. Suppose you want to follow a fixed exchange rate regime: You can either choose free capital movement or an independent monetary policy. Suppose you want to maintain free capital movement: You will have to compromise on the independence of your monetary policy. Similarly, if you want to preserve the independence of your monetary policy and maintain free capital movement, you can’t keep a fixed exchange rate system at the same time. No matter what permutations and combinations you try, choosing any of the two options would rule out the third option.
Johnny: I think you should further elaborate on this hypothesis by giving an example.
Jinny: Suppose you decide to keep fixed exchange rate and free capital movement at the same time. Free capital movement requires you not to put any restrictions on the outflows or inflows of capital.
Any volatility in the inflows or outflows will put pressure on your fixed exchange rates. In such a situation, your central bank will have to intervene in the forex market to keep the foreign exchange rate at the target. In case there is any imbalance between the demand and supply of the domestic currency against the foreign currency, there will be pressure on the exchange rate to deviate from the target. Suppose the inflow of the foreign currency is high. Then your domestic currency may appreciate due to increase in demand.
In such a situation, your central bank will be required to come out with a solution. One solution could be to absorb the excess inflow by purchasing the foreign currency from the market. The other could be to lower the domestic interest rates so that any inflow due to a difference in the foreign and domestic interest rates is curtailed. Intervention by the central bank in the market helps in keeping the exchange rate of the domestic currency within the target. But at the same time, it may jeopardize the success of the monetary policy of your central bank.
Johnny: But how is the success of the monetary policy compromised?
Jinny: The monetary policy of your central bank is based on many key assumptions. One of the most basic assumptions behind the policy is the desirable growth of money supply in the economy. For achieving the desired level of money supply, there are many instruments at the disposal of your central bank.
One such instrument is interest rates. In case the central bank is not able to keep the money supply within the desired range, it may miss the other targets set in the monetary policy.
Johnny: But, how can this assumption go wrong if the central bank itself controls the levers of money supply?
Jinny: Frequent intervention by the central bank, either for buying or selling in the forex market, makes it difficult to keep the money supply within the target range. For buying the foreign currency, the central bank has to pay in terms of domestic currency. This means that the cash which was lying with the central bank will come into the market and lead to an increase in money supply. In case the central bank is selling the foreign exchange, then it would lead to a decrease in money supply. In both cases, it would be difficult for the central bank to keep the money supply within the desirable range.
Further, the use of interest rates as a tool for controlling the inflow or outflow of foreign exchange makes one of the key instruments of monetary policy a slave of exchange rate management. This is how your monetary policy loses its independence and the prophecy of impossible trinity comes true.
Johnny: This means that it is really difficult to choose if you have too many options. But I will definitely choose to ask you if ever I have a doubt.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to them at firstname.lastname@example.org