Question

What is the trilemma for exchange rate and monetary policies for an open economy? Explain the pros and cons of a fixed exchange rate system.

PLEASE BE THOROUGH WHEN ANSWERING THE QUESTION AND EXPLANATION

Answer 1

What is a 'Trilemma'?

The impossible trinity, also called the Mundell-Fleming trilemma or simply the trilemma, expresses the limited options available to countries in setting monetary policy. It 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), and,

iii) an independent monetary policy

It is both a hypothesis based on the uncovered interest rate parity condition, and a finding from empirical studies where governments that have tried to simultaneously pursue all three goals have failed.

According to this theory, a country cannot achieve the free flow of capital, a fixed exchange rate and independent monetary policy simultaneously. By pursuing any two of these options, it necessarily closes off the third.

The pros and cons of a fixed exchange rate system:

I. The main advantages of the fixed exchange rate are:
a) It is known that speculators by their actions can lead to fluctuations in a floating exchange rate, which destabilize trade and investment. With a fixed rate the economy stays away from speculators actions.
b) The fixed exchange rate gives possibilities to predict a profit, but also supports the growing standard of living and overall economic growth.
c) Countries that have a fixed exchange rate protect their own economies.
As is known, currency fluctuations may adversely affect the economic situation and the prospects for growth. By protecting the national currency from external influences, it is possible to reduce the probability of a currency crisis.

II. The disadvantages of a fixed rate policy are:

a) This approach to monetary policy is not always effective. Everything has its price, and the country fixing rate of the national currency also has to pay for it. One of the most obvious "cons" here is the need to maintain a fixed exchange rate. It requires a lot of reserves, as the government or the central bank must constantly buy or sell the currency.
b) The problem of large foreign exchange reserves is that huge capital can lead to undesirable consequences, mainly to a higher inflation. The more currency reserves, the more its offer, which causes a rise in prices. This in turn can lead to destabilization.