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

19.4 The Choice of International Policy Regime #Notebook

19.4 The Choice of International Policy Regime #Notebook

Problems are often exposed when the central bank runs out of reserves, like in Thailand did in 1997. 

The International Monetary Fund (IMF) often provides loans to countries attempting to defend the value of their currencies. 

However, the IMF often forces borrowers to undergo fiscal austerity programs and even created a major moral hazard problem, such as repeatedly lending to the same few countries.

In China’s defense, many developing countries find it advantageous to peg their exchange rates to the dollar, the yen, the euro, the pound sterling, or a basket of such important currencies. 

The peg, as a monetary policy target similar to an inflation or money supply target, allows the developing nation’s central bank to figure out whether to increase or decrease MB and by how much.

Fixed exchange rates not based on commodities like gold or silver are notoriously fragile. Relative macroeconomic changes in interest rates, trade, and productivity can create persistent imbalances over time between the developing and the anchor currencies. 

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

19.3 The Managed or Dirty Float #Notebook

19.3 The Managed or Dirty Float #Notebook

Under a managed float, the central bank allows market forces to determine second-to-second (day-to-day) fluctuations in exchange rates, but intervenes if the currency grows too weak or too strong, keeping the exchange rate range bound. 

Central banks intervene in the foreign exchange markets by exchanging international reserves, assets denominated in foreign currencies, gold, and special drawing rights, SDRs.

If a central bank selling $10 billion of international reserves, thereby soaking up $10 billion of the monetary base.

The Assets = International reserves −$10 billion

The Liabilities = Currency in circulation or reserves −$10 billion

*The money is going back to their source.

If a central bank buys $100 million of international reserves, both MB and its holdings of foreign assets would increase.

Its Assets = International reserves +$100 million

Its Liabilities = Monetary base +$100 million

*The money is flowing out of their source.

Such transactions are influencing the foreign exchange rate via changes in MB through the money supply (MS).

Central banks also engage in sterilized foreign exchange interventions when they offset the purchase or sale of international reserves with a domestic sale or purchase. 

A central bank might offset or sterilize the purchase of $100 million of international reserves by selling $100 million of domestic government bonds.

Its Assets = International reserves +$100 million, Monetary base +$100 million

Its Liabilities = Government bonds −$100 million, Monetary base −$100 million

*Here I have a question to ask, why the Government bonds are on the liabilities side if it is originally one of the assets holdings?

Why not like this?

Its Assets = International reserves +$100 million, Government bonds −$100 million

Its Liabilities = Monetary base +$100 million, Monetary base −$100 million

Since there is no net change in MB, a sterilized intervention should have no long-term impact on the exchange rate. It is for the short-term or for the signal of desire.

Central banks can use international reserves in a fruitless attempt to prevent a depreciation, or maintenance of the peg might require increasing or decreasing the MB counter to the needs of the domestic economy.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license. 

19.2 Two Systems of Fixed Exchange Rates #Notebook

19.2 Two Systems of Fixed Exchange Rates #Notebook

Because of arbitrageurs, a type of investor who attempts to profit from market inefficiencies, the spot exchange rate, the market price of bills of exchange, could not stray very far.

The gold standard system was self-equilibrating, functioning without government intervention. But, its weakness was that the governments had so little control of its domestic monetary policy, even did not need a central bank. 

The Bretton Woods System was designed to overcome the flaws of the gold standard while maintaining the stability of fixed exchange rates. By making the dollar the free world’s reserve currency, more elastic supply of international reserves, and also allowed the United States to earn seigniorage. 

However, The Bretton Woods System had to restrict international capital flows and witnessed a massive shrinkage of the international financial system.

Reference

Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.