Forex/Impossible Trinity
The "Impossible trinity", also known as the "trilemma," is a fundamental concept in international economics that describes the relationship between three key goals of economic policy: monetary policy autonomy, exchange rate stability, and capital mobility. According to the impossible trinity, it is not possible for a country to simultaneously achieve all three objectives. Here's a breakdown of the three components:
- Monetary Policy Autonomy: Monetary policy autonomy refers to a country's ability to independently set and adjust its domestic interest rates and money supply to achieve its domestic economic goals. This includes controlling inflation, stimulating economic growth, and managing unemployment. To have monetary policy autonomy, a country must have control over its own currency and the ability to adjust its interest rates and money supply.
- Exchange Rate Stability: Exchange rate stability refers to maintaining a stable value of a country's currency relative to other currencies. It implies that the exchange rate should not experience significant fluctuations or volatility. Stable exchange rates provide certainty and predictability for international trade and investment, reducing currency risk for businesses and individuals.
- Capital Mobility: Capital mobility refers to the free flow of financial capital across national borders. It allows individuals and businesses to invest and move funds internationally, seeking higher returns or diversification. Capital mobility facilitates efficient allocation of capital and integration of financial markets.
The impossible trinity posits that a country can only achieve two out of these three objectives simultaneously. Here are the possible combinations:
- a. Fixed Exchange Rate and Capital Controls: A country can choose to fix its exchange rate to a specific currency or a pegged exchange rate regime. In this case, it must implement capital controls to restrict or regulate the movement of capital across its borders. By controlling capital flows, the country can maintain exchange rate stability while having some degree of monetary policy autonomy.
- b. Floating Exchange Rate and Capital Mobility: A country can opt for a floating exchange rate, where the value of its currency is determined by market forces. In this scenario, capital flows freely across borders, allowing for capital mobility. The country retains control over its monetary policy, adjusting interest rates and money supply based on domestic economic conditions.
- c. Fixed Exchange Rate and Full Capital Mobility: A country can choose to fix its exchange rate while allowing for full capital mobility. However, in this case, the country must sacrifice monetary policy autonomy since it cannot independently set interest rates or control the money supply. It must align its monetary policy with the currency to which it is pegged.
The impossible trinity highlights the trade-offs faced by policymakers in managing their economies. It underscores the challenges of simultaneously achieving exchange rate stability, monetary policy autonomy, and capital mobility, leading to a choice between various policy regimes based on a country's specific circumstances and objectives.
Examples
Here is examples of currencies and their positioning within the impossible trinity:
- United Arab Emirates Dirham (AED):
The United Arab Emirates (UAE) maintains a fixed exchange rate regime for its currency, the UAE Dirham. It is pegged to the US dollar at a fixed rate of 3.6725 AED per USD. This fixed exchange rate provides exchange rate stability when trading crude oil. The UAE allows capital mobility, with relatively open financial markets and minimal capital controls. However, in this case, the UAE sacrifices monetary policy autonomy as its central bank, the Central Bank of the UAE, must align its monetary policy with that of the United States to maintain the exchange rate peg. - Euro (EUR):
The Euro is the currency shared by the member countries of the Eurozone. The European Central Bank (ECB) manages monetary policy for the Eurozone, setting interest rates and implementing monetary measures across the member countries. The Euro provides exchange rate stability within the Eurozone. The currency regime allows capital mobility within the member countries, enabling the free movement of capital. However, individual countries within the Eurozone sacrifice monetary policy autonomy as their central banks no longer have the ability to set independent interest rates or adjust the money supply. - Japanese Yen (JPY):
Japan operates under a floating exchange rate regime for the Japanese Yen. The value of the Yen is determined by market forces and fluctuates against other currencies. Japan allows capital mobility, with relatively open financial markets. The Bank of Japan (BoJ) is responsible for monetary policy in the country, setting interest rates and implementing measures to manage inflation and economic growth. In this case, Japan achieves monetary policy autonomy and capital mobility, but sacrifices exchange rate stability as the Yen's value fluctuates based on market dynamics.
These examples demonstrate different combinations within the impossible trinity, showcasing how various countries prioritize and navigate the three objectives of exchange rate stability, monetary policy autonomy, and capital mobility based on their specific circumstances and policy choices.
Thai Baht before Asian financial crisis
Before the Asian financial crisis in the late 1990s, the Thai baht (THB) was an example of a currency that attempted to maintain all three aspects of the impossible trinity: exchange rate stability, monetary policy autonomy, and capital mobility. However, the pressures of maintaining this trinity eventually led to a speculation attack and the eventual floating of the baht.
- Exchange Rate Stability:
The Thai government aimed to maintain a fixed exchange rate between the baht and the US dollar to provide exchange rate stability. The exchange rate was managed through interventions in the foreign exchange market by the Bank of Thailand (BOT). The fixed exchange rate regime was intended to promote stability and support the country's export-oriented economy. - Monetary Policy Autonomy:
While attempting to maintain the fixed exchange rate, the Thai government also desired monetary policy autonomy. The BOT implemented independent monetary policies, including setting interest rates and managing the money supply, to address domestic economic conditions and control inflation. - Capital Mobility:
Thailand aimed to maintain a relatively open capital account, allowing for capital mobility. The country attracted foreign capital through liberalization measures, encouraging foreign investment and facilitating the inflow of funds. This capital mobility contributed to economic growth and development.
However, maintaining all three aspects of the impossible trinity proved challenging for Thailand. Speculators, observing weaknesses in the Thai economy and its financial system, started betting against the baht, anticipating that the fixed exchange rate would become unsustainable.
As the Thai government struggled to defend the fixed exchange rate and maintain monetary policy autonomy, it depleted its foreign currency reserves. This vulnerability exposed the baht to speculative attacks, with investors selling off the currency en masse, leading to a sharp depreciation in its value.
The mounting pressure on the baht reached a tipping point in 1997 when the Thai government eventually abandoned the fixed exchange rate regime. The baht was allowed to float freely, resulting in a significant devaluation against major currencies. This move was a response to the unsustainable nature of maintaining the trinity and the need to restore balance in the economy.
The floating of the baht, while a necessary step to restore stability, had significant economic consequences. The devaluation had ripple effects throughout the Thai economy, leading to financial and economic turmoil not only in Thailand but also in other Asian countries, triggering the wider Asian financial crisis.
The case of the Thai baht illustrates the challenges of maintaining the impossible trinity. The attempt to simultaneously achieve exchange rate stability, monetary policy autonomy, and capital mobility can create vulnerabilities and expose a currency to speculation attacks when imbalances and weaknesses emerge. Eventually, adjustments and policy shifts may be necessary to restore stability and address the limitations of the trinity.
