What is the impossible trinity, or trilemma, and why is it
important?
What are the four major types of international monetary regimes
and how do they differ?
The foreign exchange (foreign exchange rate (FX or
forex)) market described in Figure 19.1 .
Note that those were the prevailing regimes. Because nations
determine their monetary relationship with the rest of the world
individually, some countries have always remained outside the
prevailing system, often for strategic reasons. In the nineteenth
century, for example, some countries chose a silver rather than a
gold standard. Some allowed their currencies to float in wartime.
Today, some countries maintain fixed exchange rates (usually
against USD) or manage their currencies so their exchange rates
stay within a band or range. But just as no country can do away
with scarcity or asymmetric information, none can escape the
trilemma (a dilemma with three components), also known as the
impossible trinity.
In an ideal world, nations would like to have fixed exchange
rates, capital mobility, and monetary policy discretion at the same
time in order to reap their respective benefits: exchange rate
stability for importers and exporters, liquid securities markets
that allocate resources to their best uses globally, and the
ability to change interest rates in response to foreign and
domestic shocks. In the real world, however, trade-offs exist. If a
nation lowers its domestic interest rate to stave off a recession,
for example, its currency (ceteris paribus) will depreciate and
hence exchange rate stability will be lost. If the government
firmly fixes the exchange rate, capital will emigrate to places
where it can earn a higher return unless capital flows are
restricted/capital mobility is sacrificed.
As Figure 19.1 shows, only two of the three holy grails of
international monetary policy, fixed exchange rates, international
financial capital mobility, and domestic monetary policy
discretion, have been simultaneously satisfied. Countries can
adroitly change regimes when it suits them, but they cannot enjoy
capital mobility, fixed exchange rates, and discretionary monetary
policy all at once. That is because, to maintain a fixed exchange
rate, a monetary authority (like a central bank) has to make that
rate its sole consideration (thus giving up on domestic goals like
inflation or employment/gross domestic product [GDP]), or it has to
seal off the nation from the international financial system by
cutting off capital flows. Each component of the trilemma comes
laden with costs and benefits, so each major international policy
regime has strengths and weaknesses, as outlined in Figure 19.2
.
Stop and Think Box
From 1797 until 1820 or so, Great
Britain abandoned the specie standard it had
maintained for as long as anyone could remember and allowed the
pound sterling to float quite freely. That was a period of almost
nonstop warfare known as the Napoleonic Wars. The United States
also abandoned its specie standard from 1775 until 1781, from 1814
until 1817, and from 1862 until essentially 1873. Why?
Those were also periods of warfare and
their immediate aftermath in the United States—the Revolution, War
of 1812, and Civil War, respectively. Apparently during wartime,
both countries found the specie standard costly and preferred
instead to float with free mobility of financial capital. That
allowed them to borrow abroad while simultaneously gaining
discretion over domestic monetary policy, essentially allowing them
to fund part of the cost of the wars with a currency tax, which is
to say, inflation.
key takeaways
The impossible trinity, or trilemma, is one of those aspects of
the nature of things, like scarcity and asymmetric information,
that makes life difficult.
Specifically, the trilemma means that a country can follow only
two of three policies at once: international capital mobility,
fixed exchange rates, and discretionary domestic monetary
policy.
To keep exchange rates fixed, the central bank must either
restrict capital flows or give up its control over the domestic
money supply, interest rates, and price level.
This means that a country must make difficult decisions about
which variables it wants to control and which it wants to give up
to outside forces.
The four major types of international monetary regime are
specie standard, managed fixed exchange rate, free float, and
managed float.
They differ in their solution, so to speak, of the impossible
trinity.
Specie standards, like the classical GS, maintained fixed
exchange rates and allowed the free flow of financial capital
internationally, rendering it impossible to alter domestic money
supplies, interest rates, or inflation rates.
Managed fixed exchange rate regimes like BWS allowed central
banks discretion and fixed exchange rates at the cost of
restricting international capital flows.
Under a free float, free capital flows are again allowed, as is
domestic discretionary monetary policy, but at the expense of the
security and stability of fixed exchange rates.
With a managed float, that same solution prevails until the FX
rate moves to the top or bottom of the desired band, at which point
the central bank gives up its domestic discretion so it can
concentrate on appreciating or depreciating its currency.