Impossible Trinity
The impossible trinity holds that a country cannot have a fixed exchange rate, free movement of capital and an independent monetary policy all at once. It can choose any two, and giving up the third is the price of the other two.
Also called: monetary trilemma · Mundell-Fleming trilemma · policy trilemma · trilemma
The logic is arbitrage between interest rates. If capital moves freely and the exchange rate is fixed, domestic interest rates must track those of the anchor currency, or money flows in or out until the peg breaks. To set its own rates, a country must either let its currency float or block the flows with capital controls. The idea comes from the open-economy models developed by Robert Mundell and Marcus Fleming in the early 1960s.
Each corner has real examples. Hong Kong keeps a fixed rate and an open capital account and accepts US interest rates through its currency board. The United States and the euro area let their currencies float. The Bretton Woods system combined pegs with national policy freedom by keeping capital controls in place. Singapore takes a distinctive route: the Monetary Authority of Singapore manages the Singapore dollar against a trade-weighted basket within an undisclosed band, so the exchange rate itself is the policy instrument.
Practice is less tidy than the triangle. Since 2012 the IMF's institutional view has accepted that capital flow management measures can be appropriate in some circumstances, and research has questioned how independent a floating country's policy really is when global financial conditions move together. For payment firms the trinity explains why a market with a peg and falling reserves tends to reach for controls: a corridor that was open last month can close because the policy mix has to give somewhere.
In practice
Most countries pick partial positions: a managed float, a band, or controls on some flows only. The trilemma describes a pressure, not an on-off switch.
Example
A central bank pegged to the US dollar cuts its policy rate by 2 percentage points while US rates hold. With an open capital account, investors move money into dollars and reserves fall. The bank must reverse the cut, impose controls or let the peg go.
Learn more on Money Wiki
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See also
- Currency PegA currency peg is a policy under which a central bank fixes its currency's exchange rate to another currency or a basket and stands ready to buy and sell at that rate. The peg lasts only as long as the reserves and credibility behind it.
- Capital ControlsCapital controls are government limits on moving money into or out of a country, or on converting its currency at the official rate. Imposed by a central bank or finance ministry, they determine whether a payment corridor is workable at all, and in which direction.
- Currency BoardA currency board is a monetary regime that issues domestic currency only against foreign reserves, under a legal commitment to exchange it for a named anchor currency at a fixed rate. It gives up independent monetary policy in return for credibility.
- Floating Exchange RateA floating exchange rate is one set mainly by supply and demand in the foreign exchange market rather than fixed by the authorities. The central bank may intervene to calm disorderly moves but does not defend a particular level.
- Bretton Woods SystemThe Bretton Woods system was the international monetary order agreed in 1944, under which currencies were fixed to the US dollar and the dollar was convertible into gold at US$35 an ounce. It created the IMF and the World Bank and ended in 1971.
- Foreign Exchange ReservesForeign exchange reserves are the foreign-currency assets a central bank holds and can use at short notice: deposits and government securities in major currencies, gold, Special Drawing Rights and the country's reserve position at the IMF.