A nation’s choice as to which exchange rate regime to follow reflects their priorities about the economy such as inflation, unemployment, interest rate level etc. Countries may adopt to a different ER regime over time as priorities change. If the ideal currency existed in today’s world, it would possess three attributes: exchange rate stability, full financial integration and monetary independence. However, theories show that the forces of economics do not allow the simultaneous achievement of all three of them. This principle is known as the trilemma. This essay will discuss about the trilemma in terms of each policy goals and their trade-offs.
The Trilemma states that a country may simultaneously choose any two, but not all of the three policy goals. The “Trilemma triangle” is illustrated in Figure 15-16 (Feestra). Each of the three sides of the triangle, representing monetary policy autonomy, fixed exchange rate and capital mobility, depicts a potentially desirable policy goal. =Monetary policy autonomy may be desired as a means to manage the Home economy’s business cycle; =fixed exchange rate may be desired as means to promote stability in trade and investment; and =capital mobility may be desired as means to promote integration, efficiency and risk sharing.
In relation to the trade-offs of each policy, if policy makers choose to have two of the goals at the adjacent edges of the triangle, the goal at the opposite edge will be unattainable and that will be the trade off of the policy. The left vertex, labeled “capital controls” is associated with monetary policy autonomy and a fixed exchange rate regime. But it represents financial autarky – the preferred choice of most developing countries in the mid to late 1980s. The right vertex, labeled “floating exchange rate”, is associated with monetary policy autonomy and capital mobility- the preferred choice of the U.S. during the last three decades. The top vertex, labeled “no monetary policy autonomy”, is associated with exchange rate stability and capital mobility, but no monetary independence – the preferred choice of the countries forming the Euro block and of Argentina during the 1990s. The main reason for the presence of trade-offs is because when policy makers choose to use any of the two policy goals, it implies an outcome which contradicts with the third goal. By choosing fixed ER and capital mobility, they imply interest equality. This is contradicting with monetary policy autonomy in which the interest rate policies are set by each country to pursue desired national priorities. While for capital mobility and monetary policy autonomy, they imply an expected change in exchange rate, which means the country will adopt floating ER. This contradicts with the goal of fixing exchange rate. Lastly for fixed exchange rate and monetary policy autonomy, they imply a difference between domestic and foreign returns and that contradicts with capital mobility which allows complete freedom of monetary flows across national borders. The combination of these three goals will only expose the economy to financial storms.
To conclude, the trilemma is one of the economics frameworks that remain as pertinent all these years. It provides useful insights for policy makers in deciding policy choices.