International capital mobility and the “Impossible Trinity”

What is the role of economic policy? Why was it that international capital mobility prevailed before World War – I, contracted after World War – II and most revitalized in the 1970s? The answer lies in the way that international capital mobility constrains the options facing domestic economic policy. The fundamental trade-off that faces the policy makers in a global economy has been labeled the “impossible trinity” as a country cannot simultaneously pursue exchange rate stability, independent monetary policy, and perfect capital mobility. They can achieve any two goals out of three at anytime. If you have free capital flows you can use monetary policy either to have independent monetary policy or to stabilize the exchange rates but not both of them at the same time.

The exchange rate is simply the relative price of currencies, e.g., it tells you how many Euros you can buy for a Dollar. It is determined in the foreign exchange market where trillions of dollars worth of currency traded each day. Because it affects prices of goods and services sold in the world market the exchange rate is one of the most important prices in an open economy. For instance a U.S importer of T.Vs from Japan will have to pay more for the imports if the Yen becomes more expensive in terms of the U.S dollars. If the exchange rates fluctuate drastically, it may reduce the incentives for international trade. The exchange rate also affects the prices of assets. If a Swedish citizen decides to buy U.S Government bond she would first have to buy dollars so that she can pay for the bond and then once the bond is matured she would have to buy back Swedish Kronor. If the price of the dollar depreciates, its relative value declines before the bond matures then the return on the bond in terms of Swedish Kronor decreases. The exchange rate therefore also affects the expected return on assets. For these reasons one may be attracted for countries to try to stabilize the exchange rate in order to promote international trade and detract foreign investments so that the economy can grow.

A government has two major policy tools at its disposal: fiscal policy and monetary policy. Fiscal policy concerns government expenditures and tax collection while monetary policy affects the interest rate in the economy. By lowering the interest rate the monetary authorities can expand the economy and put upward pressure on prices while raising the interest rate they can contract the economy and put downward pressure on prices.

In a country that allows full capital mobility monetary policy also has a direct effect on exchange rates. If a country wants to stabilize its exchange rates and use its monetary policy to stabilize the domestic economy it has to prevent capital from moving in and out of the country. If exchange rate stability and full capital mobility are considered essential monetary policy becomes ineffective. This is because the central bank’s only objective is to stabilize the exchange rate by setting the domestic interest rate equal to the interest rate of the country to which the currency is pegged. For example in the early 1990s the Mexican Peso was fixed to the Dollar. If the U.S interest rate was raised, Mexico’s central bank had to raise the interest rate as well. Monetary policy in Mexico was therefore effectively imported from the U.S. By pegging the exchange rate to a country with low inflation and solid monetary policy it is possible to reduce domestic inflation. For example Argentina suffered hyperinflation in the late 80s and early 90s but managed to bring it down to single digits by rigidly pegging to the U.S Dollar. Finally if a country wants to keep its monetary policy independence and allow for full capital mobility it has to sacrifice exchange rate stability. The U.S for example does not stabilize its exchange rate, instead the U.S allows for full capital mobility enabling the country to invest domestically using foreign funds but at the same time controlling monetary policy to stabilize the domestic economy. As a consequence the foreign exchange value of the Dollar fluctuates in response to changes in monetary policy and capital flows.