19.1 The Trilemma, or Impossible Trinity #Notebook

19.1 The Trilemma, or Impossible Trinity #Notebook

The Free Floating Regime

The foreign exchange market that monetary authorities allow world markets to determine the prices of different currencies in terms of one another. The free float was characterized by tremendous exchange rate volatility and unfettered international capital mobility. 

Between World War II and the early 1970s, much of the world was on a managed, fixed-FX regime called the Bretton Woods System. Before that, many nations were on the gold standard.

It's the prevailing regimes when nations determine their monetary relationship with the rest of the world individually.

In the 19th century, there are silver standard, gold standard, floating in wartime, maintain fixed exchange rates (usually against USD). But just as no country can do away with scarcity or asymmetric information, none can escape the trilemma, also known as the impossible trinity.

What Is a Trilemma / Impossible Trinity? 

It is an economic decision-making theory. Unlike a dilemma, two options, a trilemma offers three solutions to a complex problem. A trilemma suggests that countries have three options to choose from when making monetary policy decisions, the free flow of capital, fixed exchange rate, and independent monetary policy.

However, the options of the trilemma are conflictual because of mutual exclusivity that makes only one option of the trilemma achievable in one shot. The theory highlights the instability inherent in using the three primary options available to a country.

Image by Julie Bang © Investopedia 2019

A: If a country can choose to fix exchange rates with one or more countries and have a free flow of capital with others, then the independent monetary policy is not achievable. The interest rate fluctuations would create currency arbitrage stressing.

B: Fixed exchange rates among all nations and the free flow of capital are mutually exclusive. Only one can be chosen at a time. If there is a free flow of capital, there cannot be fixed exchange rates. 

C: If a country chooses fixed exchange rates and independent monetary policy it cannot have a free flow of capital. Because fixed exchange rates and the free flow of capital are mutually exclusive.

Briefly summarize, only two of the three holy grails of international monetary policy, fixed exchanged rates, international financial capital mobility, and domestic monetary policy discretion can be satisfied at once. 

In history, the United States and Great Britain abandoned the specie standard and allowed their currencies to float quite freely during wartime since they found the specie standard costly and preferred instead to float with free mobility of financial capital and also allowed them to borrow abroad while simultaneously gaining discretion over domestic monetary policy.

Reference

Majaski, C. (2020, August 28). Trilemma Presents Three Equal Options but Only One is Possible at a Given Time. Retrieved October 15, 2020, from https://www.investopedia.com/terms/t/trilemma.asp