The Monetary Trilemma: Fixed Exchange Rate, Free Capital Flow, or Independent Monetary Policy?

The Trilemma

The Monetary Trilemma, also known as The Unholy Trinity, and the Impossible Trinity, is an economic principle first conveyed in the early 1960s by economists Robert Mundell and John Fleming. Such aliases describe the economic principle in which countries and central banks, face a trade-off dilemma in their currency policy manipulation. The principle highlights the infeasibility of maintaining, all three pillars of the triangle; an independent monetary policy, a fixed exchange rate, and free capital inflows. Instead, countries and policymakers must decide between the two pillars, of most priority, pertaining to their specific economic conditions.

The Pillars

Free Capital Flow:

Free capital flow allows for a beneficial increase in foreign capital investment opportunities. Thereby this increases cross-border capital inflows, which appreciates the domestic currency. However rapid shifts in global interest rate appeal may quickly revert such investments, leading to volatility within the domestic economy.

Fixed Exchange Rate:

A fixed exchange rate allows for a more standardized price of imports and exports, promoting greater trade and investment predictability. Furthermore, fixed exchange rates promote a tighter grip over monetary policy and less need for money supply manipulation with overall lower interest rates. Inflation is also often combated due to the policy's fixed nature of being anchored.

Sovereign Monetary Policy:

A sovereign monetary policy allows a country to have independent supervision over its inflation, interest rates, and conversely, its domestic currency exchange rate. Thus, it allows for greater control over policy objectives and responses to recessions and panics. A sovereign monetary system also often partially shields countries from global economic shocks.

Scenarios

A: Scenario A is exhibited today in the Eurozone, where countries currently hold a fixed common currency, with easily transferable capital inflows across borders. Yet, Eurozone countries have limited to no independence over their monetary policy, which is dictated by the European Central Bank. Furthermore, scenario A can be seen in Hong Kong, which has boasted free capital inflows while pegging its exchange rate to the USD, effectively losing its sovereign monetary policy through Interest Rate Priority.

B: The most notable explement of scenario B comes from the United States. The United States currently boasts both free capital inflows and an independent monetary policy. However, the USD is a floating currency, where volatile swings in market conditions from changing supply and demand could affect the its strength across exchanges.

C: Scenario C is mirrored in the current Chinese economy which imposes caps on foreign investment, and only after governmental approval. Furthermore, the on-shore Yuan has limited convertibility, restricted to only domestic conversions, and government-approved trade settlements / foreign investment. The Chinese on-shore Yuan is set to a strict exchange rate by the People's Bank of China, with any deviations leading to interventions by the bank. Such interventions can be achieved due to their massive reserves of USD which is estimated to be around 50% of their $3.2Tn foreign exchange reserve. China also holds around $800Bn worth of United States Treasury securities.