The Impossible Trinity

Why a country cannot simultaneously have a fixed exchange rate, free capital movement and an independent monetary policy, and how countries choose.

Countries would like to have three things at once:

A fixed exchange rate, providing stability for trade and investment.
Free capital movement, letting money flow in and out of the country.
Independent monetary policy, letting the central bank set interest rates to suit domestic conditions.

The impossible trinity, also called the trilemma, says a country can have at most two of these at the same time.

Why

Suppose a country fixes its exchange rate to the U.S. dollar and allows free capital flows. If it tries to set interest rates lower than U.S. rates, investors will move money out to earn higher returns in dollars, putting pressure on the currency. To defend the fixed rate, the central bank must raise interest rates back up. It loses control of monetary policy.

The idea comes from the Mundell-Fleming model, developed by economists Robert Mundell and Marcus Fleming in the 1960s. Mundell won the Nobel prize in 1999.

The three choices

Fixed rate plus free capital, giving up monetary independence: countries in the euro area share one currency and one monetary policy; Hong Kong pegs its currency to the U.S. dollar.
Free capital plus independent monetary policy, with a floating exchange rate: the United States, the United Kingdom and Japan.
Fixed rate plus independent monetary policy, with capital controls: China has historically managed its exchange rate and interest rates with controls on capital flows.

India’s middle path

India has chosen a middle path: a managed float, where the rupee is market-determined but the RBI intervenes to reduce volatility, partial capital account openness, with some controls, and considerable monetary independence through inflation targeting.

The currency under pressure

A country with a pegged currency cuts interest rates to boost its economy. Investors, earning less at home, move money abroad. The central bank must sell foreign reserves to defend the peg. If reserves run low, it must either raise rates again, abandon the peg, or restrict capital flows. It cannot keep all three goals.

Thinking a country can have it all

Many currency crises happened when countries tried to maintain fixed exchange rates, open capital flows and independent policy together. The trilemma explains why this is unsustainable.

Key takeaways

The impossible trinity says a country can have at most two of: fixed exchange rate, free capital movement and independent monetary policy.
It comes from the Mundell-Fleming model; Mundell won the 1999 Nobel prize.
The euro area, the U.S. and China illustrate the three choices.
India uses a managed float, partial capital openness and inflation targeting.