Trilemma- The Impossible Trinity
When making fundamental decisions about managing international monetary policy, a trilemma suggests that countries have three possible options from which to choose.
According to the Mundell-Fleming trilemma model, these options include:
1. Setting a fixed currency exchange rate
2. Allowing capital to flow freely with no fixed currency exchange rate agreement
3. Autonomous monetary policy
The mechanics of this trinity are quite simple: a country can only manipulate two of the three constituents of the trinity; it can fix its exchange rate and maintain an independent monetary policy as long as it maintains control over capital flows. Otherwise, arbitrage possibilities between domestic and foreign interest rates will arise, leading to larger capital inflows, which would inflate the quantity of money in circulation domestically.
If a country maintains both free movement of capital and monetary autonomy, it will be unable to fix its exchange rate as arbitrage opportunities will exert pressure on the exchange rate. The same reasoning applies to the last possibility, i.e. when a country maintains a fixed exchange rate in combination with monetary autonomy; under these circumstances, it has no choice but to restrict the flow of capital.
The challenge for a government’s international monetary policy comes in choosing which of these options to pursue and how to manage them. Generally, most countries favour side B of the triangle because they can enjoy the freedom of independent monetary policy and allow the policy to help guide the flow of capital.
The theory of the policy trilemma is frequently credited to the economists Robert Mundell and Marcus Fleming, who independently described the relationships among exchange rates, capital flows, and monetary policy in the 1960s. Maurice Obstfeld, who became chief economist at the International Monetary Fund (IMF) in 2015, presented the model they developed as a "trilemma" in a 1997 paper.
The French economist Hélène Rey argued that the trilemma is not as simple as it appears. In the modern-day, Rey believes that the majority of countries are faced with only two options, or a dilemma, since fixed currency pegs are not usually effective, leading to a focus on the relationship between independent monetary policy and free capital flow.
A real-world example of solving these trade-offs occurs in the eurozone, where countries are closely interconnected. By forming the eurozone and using one currency, the countries have ultimately opted for side A of the triangle, maintaining a single currency (in effect a one-to-one peg coupled with the free capital flow).
Following World War II, the wealthy opted for side C under the Bretton Woods Agreement, which pegged currencies to the U.S. dollar but allowed countries to set their own interest rates. Cross-border capital flows were so small that this system held for a couple of decades—the exception being Mundell's native Canada, where he gained special insight into the tensions inherent in the Bretton Woods system.
In the modern world, given the growth of trade in goods and services and the fast pace of financial innovation, it is possible that capital controls can often be evaded. In addition, capital controls introduce numerous distortions. Hence, there are few important countries with an effective system of capital controls, though, by early 2010, there has been a movement among economists, policymakers and the International Monetary Fund back in favour of limited use. Lacking effective control on the free movement of capital, the impossible trinity asserts that a country has to choose between reducing currency volatility and running a stabilising monetary policy: it cannot do both.
The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain – or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.