The unholy trinity of international finance

The unholy trinity states that a country cannot have all of the following at the same time: free capital mobility, a fixed exchange rate, and independent monetary policy. It can have any two of these three but not all three. Let’s first explain what these three policies are:

Free capital mobility means that the country imposes no restrictions on international investment. Capital can flow in or out of the country with no restrictions. The country may want free capital mobility in order to attract capital for investment and development.

With a fixed exchange rate, the country maintains a fixed price of its currency to the dollar or another international currency. The country may want a fixed exchange rate to keep its inflation low. If the local currency starts to depreciate, then the government buys local money and sells dollars. This creates additional demand for the local currency and stops the depreciation. In the process, however, the government is losing foreign exchange reserves (dollars) that are limited.

Independent monetary policy means that, if it wants, the country can lower its interest rates to stimulate the economy. A lower interest rate allows people to get cheaper credit and to buy houses, cars, and other goods. This leads to faster economic growth.

Now why can’t a country have all these three? An actual example will make this clear. Think of the UK in the early 1990’s. It had a (pretty much) fixed exchange rate to the German mark and free capital mobility. However, its economy was in a recession. The government wanted to lower interest rates and to make it easier for people to take credit and buy goods and services.

However, when it lowered interest rates, international investment started to leave the country since the return on investment (interest rates) was now lower. Foreign investors were selling British pounds to leave the country and were putting pressure on the pound to depreciate. The government tried to stop the depreciation by buying pounds and selling foreign exchange reserves. However, their reserves were limited and at some point they would be depleted and the pound would depreciate.

So, the government had a dilemma: should they lower interest rates and stimulate their economy but risk devaluation of the pound. Or should they keep interest rates the same to avoid the capital outflows but at the same time leave the economy in a recession. Or restrict capital flows so investors cannot leave the country?

Stimulate the economy, keep the fixed exchange rate, and let capital flow: can’t have them all. By the way, the British government chose devaluation and lowered interest rates as the chart shows. They economy recovered very fast but the pound depreciated sharply.

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