Impossible Trinity:

UNIT 9 IMPOSSIBLE TRINITY: ALTERNATIVE Alternative

Scenarios
SCENARIOS 
Structure
9.0 Objectives
9.1 Introduction
9.2 The Concept of Impossible trinity
9.3 Theoretical underpinning: Mundell-Fleming model
9.4 Impossible Trinity: alternative scenarios countries’ experience
9.5 Importance of Impossible Trinity
9.6 Impossible trinity and demand for capital account convertibility of India’s
rupee
9.7 Let us sum up
9.8 Key terms
9.9 Some Useful Books
9.10 Answer/Hints to Check your Progress Exercises

9.0 OBJECTIVES
After studying this Unit, you should be able to:
• define the concept of the impossible trinity;
• identify the components of the impossible trinity;
• examine the impossibility of achieving all three components simultaneously;
• analyse the empirical evidence in the context of the impossible trinity;
• point out the problem of rupee convertibility in meeting the conditions of the
impossible trinity; and
• highlight the importance of the study of the impossible trinity.

9.1 INTRODUCTION
Macroeconomic policy trilemma, also called the impossible trinity, means that a
country must choose between free capital mobility, exchange-rate management
and an independent monetary policy. Only two of the three are possible. A
country that wishes to fix its currency's value and has an interest-rate policy free
from outside influence cannot allow capital to flow freely across its borders. The


Contributed by Prof. S.K. Singh, Retd. Prof. IGNOU
173
Exchange Rate and
Balance of Payments articulators of the concept in the 1960s were J. Marcus Fleming and Robert A.
Mundell. The impossible trinity is a simple rule with deep implications. This
trilemma is being faced by many countries. China faced this trilemma when the
exchange rate was fixed but the country was open to cross-border capital flows, it
cannot have an independent monetary policy. Similarly, Britain has this trilemma
when it chose free capital mobility and wanted monetary autonomy it had to
allow its currency to float. There are many findings from empirical studies where
governments that have tried to pursue all three goals simultaneously have failed.
This is the prevailing global monetary scenario where the two-from-three
combinations most modern economies choose.

9.2 THE CONCEPT OF IMPOSSIBLE TRINITY

The concept is derived from the academic works of Canadian economist Robert
Mundell and British economist Marcus Fleming in the early 1960s. This principle
is frequently called ‘the Unholy Trinity,’ the ‘Irreconcilable Trinity,’ the
‘Inconsistent trinity’ or the Mundell-Fleming ‘trilemma’. This is a concept
in international economics which states that it is impossible to have all three of
the following at the same time:
i) a fixed foreign exchange rate;
ii) free capital movement (absence of capital controls);
iii) an independent monetary policy.
Under the impossible trinity (a play on 'dilemma’), two policy positions are
possible. If a nation were to adopt position a, for example, it would maintain a
fixed exchange rate and allow free capital flows, the consequence of which
would be a loss of monetary independence. A central bank can only pursue two
of the three policies mentioned above simultaneously. To see why consider this
example:
Assume that the world interest rate is at 5%. Suppose the home central bank tries
to set the domestic interest rate at a rate lower than 5%, for example at 2%. In
that case, there will be depreciation pressure on the home currency, because
investors would want to sell their low-yielding domestic currency and buy
higher-yielding foreign currency. If the central bank also wants to have free
capital flows, the only way it could prevent the home currency's depreciation is to
sell its foreign currency reserves. Since the foreign currency reserves of a central
bank are limited, once the reserves are depleted, the domestic currency will
depreciate. Hence, all three of the policy objectives cannot be pursued
simultaneously. A central bank has to forgo one of the three objectives. Three out
of three are not possible, but two out of three are not bad.

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9.3 THEORETICAL UNDERPINNING: MUNDELL – Impossible Trinity:
Alternative
Scenarios
FLEMING MODEL
The Mundell-Fleming model integrates international trade and finance into
macroeconomic theory. This approach was developed in the early 1960s by the
Canadian economist Robert Mundell (winner of the 1999 Nobel Prize in
economics) and the British economist J. Marcus Fleming (1911–1976). Both
authors were members of the IMF's research department. They independently
extended the traditional Keynesian model to an open economy set-up in which
the capital and goods markets are internationally integrated. The resulting
research constitutes the original version of the Mundell-Fleming model (Mundell
1963; Fleming 1962). The model states that, in the long run, a central bank that
hopes to conduct independent monetary policy must choose between maintaining
a fixed foreign exchange rate and allowing the free movement of capital. For
instance, a central bank that chooses to increase the total money supply by
adopting a loose monetary policy cannot hope to maintain the foreign exchange
value of its currency unless it resorts to restricting the sale of domestic currency
in the currency market.
Basic set-up*: The model is an extension of the IS-LM model. The traditional
IS-LM model deals with the economy under autarky (or a closed economy),
whereas the Mundell-Fleming model tries to describe an open economy.
Typically, the Mundell-Fleming model portrays the relationship between the
nominal exchange rate and an economy's output (unlike the relationship between
interest rate and the output in the IS-LM model) in the short run. The Mundell-
Fleming model has been used to argue that an economy cannot simultaneously
maintain a fixed exchange rate, free capital movement, and an independent
monetary policy. The traditional model is based on the following equations.
Y = C + I + G + NX (The IS Curve)
Where Y is GDP,
C is consumption,
I is investment,
G is government spending, and
NX is net exports.

M
= L (i, Y) (The LM Curve)
P

Where M is the money supply,

P is the average price,
L is liquidity, i is the interest rate, and Y is GDP
175
Exchange Rate and
Balance of Payments BoP =CA+KA (The BoP Curve (Balance of Payments))
Where CA is the current account and
KA is the capital account
IS components
C = C(Y – T, i – E(π))
Where C is consumption,
Y is GDP,
T is taxes,
i is the interest rate,
E(π) is the expected rate of inflation
I = I (i – E(π), Y – 1)
Where I is investment,
i is the interest rate,
E(π) is the expected rate of inflation,
Y – 1 is GDP in the previous period
G=G
Where G is government spending, an exogenous variable

NX = NX(e, Y,Y*)

Where NX is net exports,

e is the real exchange rate,
Y is GDP,

Y* is the GDP of a foreign country

BoP components
CA = NX
Where CA is the current account and
NX is net exports
KA = z(i - i *) + k
Where z is the level of capital mobility,
i is the interest rate,
i* is the foreign interest rate,
k is capital investments not related to i, an exogenous variable

176
 Impossible Trinity:
A critical assumption of the model is the equalization of the local interest rate to Alternative
the global interest rate. Scenarios

Changes in money supply: An increase in the money supply shifts the LM curve
downward. This directly reduces the local interest rate and forces the local
interest rate to lower than the global interest rate. This depreciates the exchange
rate of local currency through capital outflow. Hot money flows out to take
advantage of higher interest rates abroad, so currency depreciates. This leads to
the shifting of the IS curve (Y = C + I + G + NX) to the right, where the local
interest rate equalizes with the global rate. A decrease in the money supply
causes the exact opposite of the process.
Changes in government spending: An increase in government expenditure
shifts the IS curve to the right. The shift causes the local interest rate to go above
the global rate. The increase in local interest causes capital inflow, making the
local currency stronger than foreign currencies. A strong exchange rate also
makes foreign goods cheaper compared to local goods. This encourages greater
import and discourages export and hence lower net export. As a result, the IS
returns to its original level, where the local interest rate is equal to the global
interest rate. The level of income of the local economy stays the same. The LM
curve is not at all affected. A decrease in government expenditure reverses the
process.
Changes in global interest rate: An increase in the global interest rate causes
upward pressure on the local interest rate. The pressure subsides as the local rate
closes in on the global rate. When a positive differential between the global and
the local rate occurs, holding the LM curve constant, capital flows out of the
local economy. This depreciates the local currency and helps boost net export.
Increasing net export shifts the IS to the right. This shift continues to the right
until the local interest rate becomes as high as the global rate. A decrease in the
global interest rate causes the reverse to occur.
Changes in money supply: Under the fixed exchange rate system, the local
central bank only changes the money supply to maintain a specific exchange rate.
Suppose there is pressure to depreciate the domestic currency's exchange rate
because the supply of domestic currency exceeds its demand in foreign exchange
markets. In that case, the local authority buys a domestic currency with foreign
currency to decrease the domestic currency's supply in the foreign exchange
market. This returns the domestic currency's exchange rate to its original level.
Suppose there is pressure to appreciate the domestic currency's exchange rate
because the currency's demand exceeds its supply in the foreign exchange
market. In that case, the local authority buys a foreign currency with domestic
currency to increase the domestic currency's supply in the foreign exchange
market. This returns the exchange rate to its original level. A revaluation occurs
when there is a permanent increase in the exchange rate and hence, a decrease in
the money supply. Devaluation is the exact opposite of revaluation. 177
Exchange Rate and i IS1 LM
Balance of Payments
IS LM1

FE
iw

An increase in government spending forces the monetary authority to flood the

market with local currency to keep the exchange rate unchanged.
Figure 9.1: Changes in IS-LM due to changes in Money supply
The local monetary authority in the framework of a fixed system controls the
exchange rate. To maintain the exchange rate and eliminate pressure from it, the
monetary authority purchases foreign currencies with local currency until the
pressure is gone, i.e., back to the original level. Such action shifts the LM curve
in tandem with the direction of the IS shift. This action increases the local
currency supply in the market and lowers the exchange rate—or rather returns the
rate to its original state. In the end, the exchange rate stays the same but the
general income in the economy increases.
If the global interest rate increases above the domestic rate, capital flows out to
take advantage of this opportunity. Hot money flows out of the economy. This
would depreciate the home currency, so the central bank may buy the home
currency and sell some of its foreign currency reserves to offset this outflow.
This decrease in the money supply shifts the LM curve to the left until the
domestic interest rate is the global interest rate. The opposite occurs if the global
interest rate declines below the domestic rate. Hot money flows in, and the home
currency appreciates. The central bank offsets this by increasing the money
supply (selling domestic currency, buying foreign currency), the LM curve shifts
to the right, and the domestic interest rate becomes the global interest rate.
Differences from IS-LM: It is worth noting that some of the results from this
model differ from the IS-LM because of the open economy assumption. The
result for a large open economy on the other hand falls within the result predicted
by the IS-LM and the Mundell-Fleming models. The reason for such a result is
that a large open economy has both the characteristics of autarky and a small
open economy. In the IS-LM, the interest rate is the key component in making
both the money market and the goods market in equilibrium. Under the Mundell-
Fleming framework of a small open economy, the interest rate is fixed and
equilibrium in both markets can only be achieved by a change in the nominal
exchange rate.
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 Impossible Trinity:
Example: A much-simplified version of the Mundell-Fleming model can be Alternative
illustrated by a small open economy, in which the domestic interest rate is Scenarios
exogenously predetermined by the world interest rate (r=r*). Consider an
exogenous increase in government expenditure, the IS curve shifts upward, with
LM curve intact, causing the interest rate and the output to rise (partial crowding
out effect) under the IS-LM model. Nevertheless, as the interest rate is
predetermined in a small open economy, the LM1 curve (of exchange rate and
output) is vertical, which means there is exactly one output that can make the
money market in the equilibrium under that interest rate. Even though the IS1
curve can still shift up, it causes a higher exchange rate and the same level of
output (complete crowding out effect, which is different in the IS-LM model).
This example makes an implicit assumption of a flexible exchange rate. The
Mundell-Fleming model can have completely different implications under
different exchange rate regimes. For instance, monetary policy becomes
ineffective under a fixed exchange rate system, with perfect capital mobility. An
expansionary monetary policy resulting in an outward shift of the LM curve
would in turn make capital flow out of the economy. The central bank under a
fixed exchange rate system would have to intervene by selling foreign money in
exchange for domestic money to depreciate the foreign currency and appreciate
the domestic currency. Selling foreign money and receiving domestic money
would reduce real balances in the economy, until the LM curve shifts back to the
left, and the interest rates come back to the world rate of interest i*.
*This section is largely based on the contributions of over twenty authors
(http://gobernanzamedioambiental.org/brugger/Mundell%E2%80%93Fleming%20model.pdf)

There is another way to understand the trilemma. Let us look at the diagram
given below:

Open Capital Account` (A)

Fixed Exchange Independent

rate (B) Monetary Policy (C)

Figure 9.2: The “Impossible trinity” of Capital, Money and exchange

The diagram represents the impossible trinity. In this schematic, the open capital
account is labelled "A", the fixed exchange rate is labelled "B," and the
independent monetary policy is labelled "C."

179
Exchange Rate and
Balance of Payments In terms of the Figure 9.2 (Oxelheim, 1990), the following are the options:
i) “A”: A stable exchange rate and free capital flows (but not an independent
monetary policy because setting a domestic interest rate that is different from
the world interest rate would undermine a stable exchange rate due to
appreciation or depreciation pressure on the domestic currency).
ii) “B”: An independent monetary policy and free capital flows (but not a stable
exchange rate).
iii) “C”: A stable exchange rate and independent monetary policy (but no free
capital flows, which would require the use of capital controls).
The theory of the impossible trinity is that a country can't achieve A+B+C at the
same time. Any country that attempts this is doomed to fail. That's the crux of the
theory. Mundell was of the view that the effects of monetary and fiscal policy in
an open economy depend on capital mobility. In particular, he has highlighted the
importance of exchange rate systems. Under floating exchange rates, monetary
policy is a powerful tool; fiscal policy is powerless. Under fixed exchange rates,
fiscal policy is effective.

Check Your Progress 1

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What do you mean by impossible trinity?
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2) Describe the main components of the Mundell-Fleming model.

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3) Explain the process involved in the Mundell-Fleming model.
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 Impossible Trinity:
9.4 IMPOSSIBLE TRINITY: ALTERNATIVE Alternative
SCENARIOS COUNTRIES’ EXPERIENCE Scenarios

The choices made by policymakers are not so clear-cut. The concept of the
impossible trinity went from theoretical curiosity to becoming the foundation
of open economy macroeconomics in the 1980s, by which time capital
controls had broken down in many countries, and conflicts were visible
between pegged exchange rates and monetary policy autonomy. While one
version of the impossible trinity is focused on the extreme case – with a perfectly
fixed exchange rate and a perfectly open capital account, a country has absolutely
no autonomous monetary policy; the real world has thrown up repeated examples
where capital controls are loosened, resulting in greater exchange rate rigidity
and less monetary-policy autonomy.
Europe's exchange rate mechanism (ERM) was born after the death of the
Bretton Woods System. No member violated the impossible trinity. The German
unification in 1989 was the first big shock. The second big shock was the single
market. The single market required capital mobility and free movement of
capital. With fixed exchange rates and no control over capital, member nations
had to implicitly give up their autonomy over monetary policy. Since Germany
was the biggest economy, they aligned themselves with the policies of Germany's
Bundes Bank. But the reunification called for a very tight monetary policy in
Germany and, therefore, in other member-nations. Britain needed something
loose and different. Britain walked out of the ERM because it knew that the
impossible trinity could not be violated. Britain regained interest rate autonomy,
retained capital mobility and regained floating exchange rates. This explains why
Britain is a non-euro country.
In practice, many emerging markets are fearful of letting the exchange rate move
sharply, so they choose to sacrifice either free capital mobility (by introducing
capital controls, or by adding to or depleting their foreign-currency reserves) or
monetary independence, by giving priority to currency stability over other
targets. China for instance is currently up against the classic trilemma involving
the impossible trio. The country wants to keep the Yuan stable because it aspires
to make it an international reserve currency akin to the US dollar. So the currency
is allowed to fluctuate only 2 per cent on either side of a peg determined by the
Chinese central bank. China is also trying to accelerate the move towards making
the Yuan freely convertible as that is one of the prerequisites for an international
currency. Attempting to sustain the current rate of exchange will lead to the
depletion of forex reserves. This is impeding China from following the
independent monetary policy needed to kick-start growth. China wants
eventually to liberalise its capital account as a stepping stone to a modern
financial system. To do so, it will have to live with a volatile yuan.
With open capital markets and a currency board, Hong Kong implicitly accepts
foreign monetary policy, which can sometimes be too tight or too easy. The fixed 181
Exchange Rate and
Balance of Payments exchange rate provides a stable environment for importers and exporters.
Countries such as Australia and New Zealand have chosen domestic price
stability in the form of an inflation target, and accept a high degree of exchange
rate volatility. India has a multiple indicators approach and looks at everything.
Surging capital flows is a problem in most countries. Countries like Korea, NZ
and the Philippines have inflation targets and capital flows have been a problem
with them. Ideally, there should have seen some appreciation in these countries.
However, the currency has appreciated only in India, Korea and China from 1994
levels. The consensus is to have free capital inflows, have a stable monetary
policy and let the currency float.
India has been able to actively manage the exchange rate and limit exchange rate
volatility relative to other emerging market economies, by building up
international reserves and intervening actively in the foreign exchange market.
Such reserve management has also helped to some extent in regaining control
over monetary policy even in the face of capital inflows. However, the steps RBI
took in 2013 to defend the currency have resulted in a reversal of the direction of
interest rates in the economy. The then RBI governor D. Subbarao, in his
statement on the review of the monetary policy on 30 July 2013 noted that India
is currently caught in a classic 'impossible trinity’. Put differently, to protect the
rupee, RBI has lost some independence in how it makes the monetary policy.
In sum, in the modern world, given the growth of trade in goods and services
along with fast paced of financial innovation and lacking effective control over
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 combination of the three policies is known to
cause the financial crisis. The Mexican peso crisis (1994–1995), the 1997 Asian
financial crisis (1997–1998), and the Argentinean financial collapse (2001–2002)
are often cited as examples. In particular, the East Asian crisis (1997–1998) is
widely known as a large-scale financial crisis caused by the combination of the
three policies which violate the impossible trinity. Mundell always says to let
capital flow and defend exchange rates. Hélène Rey has observed that “for the
past few decades, international macroeconomics has postulated the ‘trilemma’:
with free capital mobility, independent monetary policies are feasible if and only
if exchange rates are floating. The global financial cycle transforms the trilemma
into a ‘dilemma’ or an ‘irreconcilable duo’: independent monetary policies are
possible if and only if the capital account is managed”.
In this context, it is well to remember what James Rickards has emphasized;
there is one big exception to the impossible trinity. That's the United States. The
U.S. sets interest rates independently and has an open capital account. The U.S.
does not officially peg the dollar to any other currency (thus technically not
breaking the Impossible Trinity). But it does work with other countries to allow
them to informally peg to the dollar. Why does the U.S. not suffer adverse
182
 Impossible Trinity:
consequences? Because the U.S. does not need foreign exchange. The dollar is Alternative
the leading reserve currency in the world (about 60% of global reserves and Scenarios
about 80% of global payments), so the U.S. can never run out of foreign
exchange to pay for things, it can just print more dollars! This is what the French
called the dollar's ‘Exorbitant Privilege’ in the 1960s.

Check Your Progress 2

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) Why is it difficult for countries to circumvent the impossible trinity?

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2) Discuss the policies adopted by European countries

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3) Give examples of financial crises because of the non-observance of the

impossible trinity.

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9.5 IMPORTANCE OF IMPOSSIBLE TRINITY

The model serves as an introduction to the formal theory of policymaking. This
model cannot be relegated to textbooks only. It affects the policies of countries
and central banks across the globe. This concept is impossible to ignore,
especially if one is a keen follower of macros. Theoretically, policy-makers
should manage macroeconomic policies following the rule that ‘for each goal
might correspond only one macroeconomic policy instrument’. This means that
even a floating exchange rate regime does not release policy-makers from facing
the ‘trilemma’ of economic policy. No government can achieve more targets than
it has instruments. The Mundell model implied an optimal assignment and, more
important, was drawn up within the Tinbergian target-instrument framework.
Many of the more sophisticated models followed have continued in this tradition.
In this regard, the Mundell-Fleming model has been successful in the theoretical
predictions in matching empirical facts such as the effects of U.S.
macroeconomic policies in the 1980s and helping explain the model's influence
among academics and policymakers. Mundell's contribution to international
macroeconomics is extraordinary. The ‘impossible trinity’ is among his best. It is 183
Exchange Rate and
Balance of Payments axiomatic. Understanding and using the impossible trinity works wonders if one
can spot the right conditions and set up the trades in advance of the inevitable
policy failures of the central banks. Those failures (which do happen) represent
some of the best profit-making opportunities of all. While citing the example of
England, James Rickards has observed how by understanding the impossible
trinity George Soros broke the Bank of England on September 16, 1992 (still
referred to as ‘Black Wednesday’ in British banking circles). Soros also made
over $1 billion that day. The importance of the concept may be recapitulated as
under:
i) The impossible trinity is a tool to separate countries with good policies from
those with bad policies. It is also a tool used to make accurate forecasts based
on the sustainability of those policies.
ii) Using the impossible trinity to spot trends and make investment decisions
requires a lot of analysis. There are three policies that can go wrong (A, B,
and C above), and three ways to fix them (again, A, B, and C). That gives
nine basic scenarios (3 x 3 = 9), and many more when one considers hybrid
or combined policies, (a country could devalue its currency and slap on
capital controls at the same time). There are always expert practitioners on
the lookout for non-sustainable policies that are bound to break. This is a kind
of strategic intelligence.
iii) The policy challenges associated with the ‘impossible trinity’ have become
more relevant to developing countries as more and more of them have taken
steps to liberalize the capital account of their balance of payments to permit
freer flows. Over the years, several countries have mishandled this trilemma.
It is important to remember that domestic policy-makers should not deviate
from this discipline from time to time.
iv) Countries must keep in mind the key lessons to be drawn from the experience
of other countries. Flouting the basic premises of the Mundell – Fleming
model (the ‘impossible trinity’) has inevitable consequences. It leads to
unsustainable macroeconomic imbalances. Failure to take early remedial
action would result in a steady deterioration of macroeconomic fundamentals.
The earlier the remedial measures are implemented the less painful will be
the adjustment. The painful corrective austerity measures have eventual
political costs, particularly if stabilization measures are implemented without
supporting structural reforms which strengthen the growth framework of the
economy.
v) Impossible trinity has highlighted the main challenges that emerging
economies face today as they integrate with global capital markets in
managing the trade-offs between the trinity. The rise in the volatility of global
capital flows has made macroeconomic management increasingly complex,
especially for emerging economies that are striving to achieve a balance
184 between the diverse objectives of robust growth rate, sustainable current
 Impossible Trinity:
account deficit, competitive exchange rate, access to adequate external capital Alternative
for financing investment, moderate inflation, and sufficient international Scenarios
reserves. This has also reignited the debate on suitable macroeconomic
management measures. Sooner or later bad economics becomes bad politics.
The authorities must move beyond politics to embark upon sound economic
policy-making which recognises the discipline imposed by the 'impossible
trinity’.

9.6 IMPOSSIBLE TRINITY AND DEMAND FOR

CAPITAL ACCOUNT CONVERTIBILITY (CAC)
OF INDIA’S RUPEE
The move towards making the Indian rupee fully convertible on the capital
account has attracted considerable debate. The critics have claimed that full
convertibility or capital mobility and freely floating exchange rates are inimical
to India's interests. The critics have referred to Britain's crisis in 1992 and the
Asian crisis in 1997 to buttress their criticism. However, the criticisms have been
contested by the advocates of capital account convertibility. Advocates have
argued that capital mobility and freely floating exchange rates are not joint policy
issues. One can exist without the other. The crisis in Britain erupted when
policymakers understood the axiomatic inviolability of the impossible trinity.
The Asian crisis was craftily brewed by central banks that dodged the impossible
trinity.
In a managed float economy, the rupee floats somewhat. Although the rupee is
not pegged to any currency, India does not allow free movement on the capital
account. Capital control is put in place to preserve financial stability as large
inflows and outflows can lead to financial instability. The RBI is not defending
the rupee by selling foreign currency in the market, but if it did, the impact on the
interest rate would have been the same. Selling foreign exchange would reduce
the supply of rupees in the market which would have resulted in higher rates. But
the RBI has made it clear that it would like to move towards full convertibility
over the long term. If that happens, RBI may not be able to maintain the right
reign on interest rates. An independent monetary policy will be difficult given
that the rupee is nowhere close to becoming a reserve currency like the dollar.
The researchers have observed that India's capital account liberalization that
began in the early 1990s has since then been a steady albeit slow and gradual
process. Regarding opening up the financial markets to foreign investment,
Indian authorities have always proceeded with a lot of caution and apparent
scepticism about the benefits of foreign capital balanced against the potential
instability that such capital inflows might trigger. On one hand foreign capital
offers a diversification of opportunities to investors and provides avenues to
bridge the gap between domestic saving and investment, and on the other
unbridled flows can fuel inflationary pressures, fan asset price bubbles, and 185
Exchange Rate and
Balance of Payments sudden reversals in capital inflows can lead to instabilities and even crises in
financial and currency markets. The decade of the 1990s was replete with several
such incidents of financial crises all over the emerging world as seen in Mexico
(1994), East Asia (1997), Russia (1998), Brazil (1999) and eventually Argentina
(2000). Rampant volatile debt inflows in the domestic economies triggered all
these episodes of crises. (Reddy, 2008).
Though India is now more open in absolute terms than it used to be during the
early 1990s, the cautious and gradual approach towards capital account
liberalization has meant that India has significantly lagged behind other
countries. Even today, more than two decades after India started opening up its
capital account, there exists an extensive array of restrictive controls imposed by
authorities on different categories of foreign investment to actively manage the
capital account. India’s capital account seems to be only partially open and the
exchange rate is in a managed floating regime. India has also been accumulating
large amounts of foreign currency reserves since the early 2000s.
India does not allow free movement on the capital account. Capital control is put
in place to preserve financial stability as large inflows and outflows can lead to
financial instability. Issues related to the capital account constitute a subject upon
which divergent views have existed and a professional consensus is yet to
emerge. CAC is not a standalone objective but a means for higher and stable
growth. There is no need or use to hustling towards CACs; the movement should
be at a pace the country is comfortable with, considering all relevant factors and
the environment, in which the country has to function.

Check Your Progress 3

Note: i) Use the space given below for your answers.
ii) Check your progress with those answers given at the end of the unit.
1) What are the implications of the impossible trinity in policymaking?

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2) Why do we study the impossible trinity? Point out its practical significance.

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3) What is capital account convertibility (CAC)? How are capital A/c
convertibility and current A/c convertibility different?
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186
 Impossible Trinity:
9.7 LET US SUM UP Alternative
Scenarios
After completion of this unit, you will understand that, the impossible trinity also
called the Mundell-Fleming trilemma or simply the trilemma expresses the
limited options available to countries in setting monetary policy. According to
this theory, a country cannot simultaneously achieve the free flow of capital, a
fixed exchange rate and independent monetary policy. Pursuing any two of these
options necessarily closes off the third.
The ‘impossible trinity' is a fundamental contribution of the Mundell-Fleming
framework. Confronted with this Trilemma policymakers have to choose a
combination of any two objectives because all three goals can be mutually
inconsistent.
Today most countries allow their currencies to float. That way, the currency
adjusts to the waxing and waning of capital flows, allowing interest rates to
respond to the domestic business cycle. The trilemma is not as simple as it
appears since most countries lack monetary policy independence whether or not
they have free exchange rates and capital flows. The reason has to do with the
overwhelming influence of the Federal Reserve.
With autonomous monetary policy, the exchange rate is on autopilot. With fixed
exchange rates, the monetary policy is on autopilot. This is what makes the entire
learning so good. One not only knows what the impossible trinity is, but one also
knows which country is doing what.
India adopted a calibrated and hierarchical approach towards capital account
liberalization, prioritizing some flows over others. CAC need not be India’s
overriding priority.

9.8 KEY WORDS

Trade-offs Something is being given up for something
else.
Asian financial crisis The Asian Financial Crisis of 1997 (also called
the ‘Asian Contagion’)was a financial crisis
that affected many Asian countries, including
South Korea, Thailand, Malaysia, Indonesia,
Singapore and the Philippines. After posting
some of the most impressive growth rates in the
world at the time, the so-called ‘tiger
economies' saw their stock markets and
currencies lose about 70% of their value.
Tinbergen target- According to the well-accepted 'Tinbergen
instrument framework Rule’ a policy instrument can be effective only
if it has a single objective. No government can
achieve more targets than it has instruments. 187
Exchange Rate and
Balance of Payments For example, when there are two targets, two
policy instruments are required to achieve both
objectives. The interest rate is better suited to
target domestic imbalances. Targeting
exchange rates through market intervention is
better suited to targeting external imbalances.
The Tinbergen Rule has been used to criticise
multi-target policy instruments for being
inefficient.
Macroeconomics Management Management of issues relating to GDP, fiscal
policy, monetary policy, trade policy, growth
strategies, sovereign wealth funds, etc.
Capital account Is a feature of a nation's financial regime that
convertibility (CAC) centres on the ability to conduct transactions of
local financial assets into foreign financial
assets freely or at country-determined exchange
rates.
Financial Integration There is no universal definition of ‘financial
integration’. Nevertheless, the term typically
encompasses concepts like financial openness,
free movement of capital and integration of
financial services. The Financial System
Inquiry of 2014 considered financial integration
to be a country’s ‘financial connectedness’ with
other countries, noting that greater financial
integration tends to increase capital flows and
equalise prices and returns on traded financial
assets in different countries.
International Reserves International reserves are any kind of reserve
funds that can be passed between the central
banks of different countries. International
reserves are an acceptable form of payment
between these banks. The reserves themselves
can either be gold or else a specific currency,
such as the dollar or euro.
Capital control Capital control represents any measure taken by
a government, central bank or other regulatory
body to limit the flow of foreign capital in and
out of the domestic economy. These controls
include taxes, tariffs, outright legislation and
volume restrictions, as well as market-based
188 forces. Capital controls can affect many asset
 Impossible Trinity:
classes such as equities, bonds and foreign Alternative
exchange trades. Scenarios

Capital movement The transfer of capital between countries. It

refers to the movement of money for
investment, trade or business production,
including the flow of capital within
corporations in the form of investment capital,
capital spending on operations and research and
development (R&D).
Sterilized Intervention Is the purchase or sale of foreign currency by a
central bank to influence the exchange value of
the domestic currency, without changing the
monetary base. Empirical evidence suggests
that sterilized intervention is generally
incapable of altering exchange rates.

9.9 SOME USEFUL REFERENCES

Acharyya, Rajat (2014): International Economics, 1st edition, Oxford University
Press, New Delhi
Carbaugh, Robert J (2015): International Economics, 11th edition, Cengage
Learning India Pvt. Ltd., New Delhi
Gowland, David (2012): International Economics, Chapter 7, Barnes and Noble
Books, Totowa, New Jersey, USA
Krugman, Paul R., Maurice Obstfeld, and Marc Melitz (2014): International
Economics: Theory and Policy, 10th edition, Pearson Education Ltd., Harlow,
England, UK
Mundell–Fleming model
http://gobernanzamedioambiental.org/brugger/Mundell%E2%80%93Fleming%2
0model.pdf (contains contributions of Andyjsmith, AtD, Atlastawake, Beacharn,
Beland, Bender235, Charles Matthews, Earth, Eric Shalov, Excirial, Hu12,
Jackzhp, Jamila89, Jastrow, John Quiggin, Luizabpr, Maurreen, OdileB, RJFJR,
Radagast83, Rich Farmbrough, Rinconsoleao, SimonP, Skapur, Yalst, 80
anonymous edits)
Oxelheim, L. (1990): International Financial Integration, Berlin, Springer
Verlag
Rey, Hélène (2015): Dilemma not Trilemma: the global financial cycle and
monetary policy independence, National Bureau of Economic Research, Working
Paper 21162 (http://www.nber.org/papers/w21162.pdf)
Salvatore, Dominick (2004): International Economy, 8th edition, Wiley India Pvt.
Ltd., New Delhi 189
Exchange Rate and
Balance of Payments Sengupta, Rajeswari (2015): The Impossible Trinity: Where does India stand?
Indira Gandhi Institute of Development Research, WP-2015-05, Mumbai, March
http://www.igidr.ac.in/pdf/publication/WP-2015-05.pdf
What is the Impossible Trinity?
https://dailyreckoning.com/what-is-the-impossible-trinity/

9.10 ANSWERS/HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check your progress 1
1) See section 9.2
2) See section 9.3
3) See section 9.3

Check your progress 2

1) See section 9.4
2) See section 9.4
3) See section 9.4

Check your progress 3

1) See section 9.5
2) See section 9.5
3) See section 9.6

190