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Impossible TrinityINTRODUCTION

What is Impossible Trinity

Impossible trinity or trilemma in monetary policy means that a country cannot have a fixedexchange rate, free movement of capital and an independent monetary policy at the sametime.

Let’s understand this theoretically. Suppose, a country that has a fixed exchange rateraises interest rates to curb in inflation. Higher interest rates will attract foreign capital. Sincethe country has a fixed exchange rate, the central bank will have to buy foreign exchange tomaintain the peg which will lead to in ection of domestic currency in the market. !he rise inavailability of money in the market will bring down its cost "read interest rate# and defeat the

central bank’s idea of curbing inflation by raising interest rates. !his is why a lot of countriesalso have capital control in place which allows them to maintain stable currency and havemore authority on the monetary policy.

It states that policy makers in open economies often face a three$way tradeoff between thecontradictory policy ob ectives namely, a stable exchange rate, an independent monetary

policy designed to target domestic inflation and open capital markets. %onfronted with this!rilemma policy makers have to choose a combination of any two ob ectives because allthree goals can be mutually inconsistent. &or instance, supposing policy makers in aneconomy with fixed exchange rate raise the interest rate in order to control domestic inflation

'a move that also increases the difference with world interest rate. (iven arbitrage in opencapital markets and the underlying interest rate parity condition, such a move will attractcapital inflows into the domestic economy resulting in an appreciating pressure on the fixedexchange rate. Subse)uent intervention in the foreign exchange market to buy internationalreserves and sell domestic currency in order to maintain the fixed exchange rate in the face of the appreciation pressure will end up defeating the original ob ective of controlling domesticinflation. !hus while the *S is an example of an economy pursuing flexible exchange rates,open capital markets and independent monetary policy, countries belonging to the +uro onefollow a combination of exchange rate stability, financial integration and ero monetaryindependence.

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