The Holy Trinity

1) The impossible trinity in the domain of international economics refers to the policy constraint that countries face.

2) It is impossible for a country to have all of the following a) Free capital flow b) Fixed exchange rate c) Independent monetary policy

Example: If a country opts for free capital flow and a sovereign monetary policy (operating in arm b) then it has to keep a flexible exchange rate system. Similarly, if a country operates a fixed exchange rate system and opts for a sovereign monetary institution (operating in arm C), then it has no choice but to restrict movement of capital across its borders.

3) To see why this is the case, let us consider a country that tries to maintain all 3 policy options. a) Country embarks on an expansionary monetary policy. b) This means that the domestic interest rate in the country is lower than the global interest rate. c) This means that investors borrow in the currency of the country and lend it abroad to make profit. d) As there are no capital controls, this flight of capital takes place on a massive scale. e) This exerts downward pressure on the domestic currency and causes it to depreciate. f) But now the country has to maintain the fixed exchange rate and hence has to buy the foreign currencies and keep it in its reserves. g) Thus, the country’s domestic currency is continuously depreciating while at the same time, it is using that weak currency to buy foreign currency. This will continue until it is no longer feasible to continue the operation.

4) Most countries (including US) opt for operating under arm b, while the European Union nations operate under arm a.

5) The pursuit of all the 3 policy choices has often caused crises like the Mexican Peso Crisis or the East Asian Economic Crisis.