The impossible trinity: how the free movement of capital comes with a cost

Source: The post is based on the article “The impossible trinity: how the free movement of capital comes with a cost” published in The Hindu on 6^th October 2022.

What is the News?

Recently, the U.S. Federal Reserve has been raising interest rates to fight rising prices. This brought the focus back to the impossible trinity or the trilemma.

In a world where capital is largely free to move across borders, the Fed rate hike has led many investors to pull money out of the rest of the world and rush to the U.S. in search of higher yields. Thus putting pressure on many currencies such as the Indian rupee.

What is the impossible trinity or the trilemma?

The idea was proposed independently by Canadian economist Robert Mundell and British economist Marcus Fleming in the early 1960s.

Accordingly, the impossible trinity, or the trilemma, refers to the idea that an economy cannot pursue independent monetary policy, maintain a fixed exchange rate, and allow the free flow of capital across its borders at the same time.

According to economists, any economy can choose to pursue only two out of the three policy options noted above simultaneously in the long-run.

The impossible trinity or the trilemma in the present world

Practically, in today’s world, capital is largely free to move across borders with ease. So, the choice before policymakers is between maintaining a fixed exchange rate and pursuing an independent monetary policy. So, the government may follow any of the two conditions below.

Condition 1: If policymakers choose to peg or maintain the value of their currency at a certain level against a foreign currency, this decision will limit the monetary policy they adopt in the long-run. This is because the decision to peg the exchange value of the currency can tie down the hands of central bankers when it comes to their domestic monetary policy stance.

Condition 2: If policymakers of a country choose to pursue independent monetary policy, they may not be able to maintain the foreign exchange value of their currency at the desired peg. This is because the kind of monetary policy adopted by an economy’s central bank invariably influences the exchange value of its currency against foreign currencies.

Note: In the past, when strict capital controls were used to regulate the flow of capital across borders, economies could choose to pursue independent monetary policy and still hope to maintain a certain exchange value against foreign currencies.

The impossible trinity or the trilemma on RBI

The Reserve Bank of India may also face the dilemma of choosing between maintaining the value of the rupee and holding on to its monetary policy independence. For example, the present Fed rate hike has been increasing pressure on the rupee. The Rupee has depreciated almost 10% against the U.S. dollar this year.