IMPOSSIBLE TRINITY

A PEEK INTO THE REALM OF IMPOSSIBILITY

GROUP 6

FIXED EXCHANGE RATE A currency’s value is fixed against the value of another single currency

Used to stabilize the value of a currency against the currency it is pegged to

Makes trade and investments between the two currency areas easier and more predictable

Reduces volatility and fluctuations in relative prices

Eliminates exchange rate risk by reducing the associated uncertainty

Useful for small economies

FREE CAPITAL MOVEMENT Freedom to move money to other countries and invest easily

Governments want to make easy for companies to invest in their country, setting up factories and employing people

Making global movement as easy as possible, money can move to the places where it is needed the most and can make the best return

INDEPENDENT MONETARY POLICY

Control over interest rates

Adjusted to suit the specific needs of the economy

If the economy is in a recession or a slow down, interest rates can be lowered to give the economy a boost.

If the economy is overheating or in a bubble with too high inflation, interest rates can be raised

Free Flow of Capital

Fixed Exchange RateAutonomous Monetary

Policy

WELCOME TO MICKEY-LANDA prosperous land with rich natural resources

Central Bank Governor of MickeyLand learns of the

Impossible Trinity.

‘MICKEYLAND’ WANTS ECONOMIC GROWTH – (Scene 1)

The of Mickey-Land is worried about the

recent Economic Slowdown

He decides to encourage all kinds of business in Mickey-

Land by giving loans at Low Interest Rates

Mickey Dollars are easily available

Businesses are growing

MICKEY $ IN TROUBLE (Scene 2)Mickey Dollars are now easily

available in MickeyLand. Enter Uncle Scrooge (U.S)

Rich Uncle Scrooge(U.S) now sees no incentive in keeping

his money in MickeyLand, since Interest Rates are low

Duckling 1(from Nigeria) offers much better Interest Rates. Uncle Scrooge(U.S) shifts money to Nigeria

NOTE : This is because MickeyLand ALLOWS FREE FLOW OF CAPITAL.

BACK IN MICKEYLAND(Scene 3)There is a shortage of Uncle

Scrooge $ in MickeyLand and Mickeyland $ value depreciates in

the World Market

MickeyLand wanted FIXED EXCHANGE RATE, and it

‘buys back’ Uncle Scrooge $, increasing demand for it.

Large amounts of MickeyLand $ are needed to convince Uncle

Scrooge! This reduces liquidity in MickeyLand $

Liquidity reduces Interest Rates Rise!

WHAT IF…..(Scene 4)MickeyLand decided that they can

control everything by imposing Capital Controls

Uncle Scrooge is prohibited from Capital Transfer into Nigeria

However there is Mr. UnniKrishnan (UK), who wants to

invest in MickeyLand but is a victim of the Prohibition

Capital Flow Controls cause fluctuations in Import and Export

and MickeyLand suffers.

IN A NUTSHELL……. If interest rates were lowered to boost the economy, capital would leave the country to get a

better return

EXAMPLES…

Independent MonetaryPolicy

Free Capital Flow

Fixed Exchange Rate

Ireland U.S

China

Asian Financial Crisis: Trinity explained

Marked by Fixed exchange rates, Free Capital Flows and High Interest rates

Growth of economic bubble fueled by hot money which was expensive, high short term interest rates

Large private current account deficits led to higher debts to GDP

External shocks culminated in increase of US interest rates which led to outflow of capital

Raise of US dollar made the pegged currencies strong and less competitive in global markets, higher Current Account deficit

Governments in return increased interest rates. Reserves couldn’t sustain it and led to floating

Aftereffects: This led much of the developing world to abandon fixed exchange rates

The western institutions no more frown modest capital controls

Asian countries built up large reserves as contingency for future

INDIAN SCENARIO Gradual financial liberalization, first domestic, then foreign

More market-determined exchange rate system and current account convertibility�

Slow and incomplete capital account liberalization: “Complex, discretionary and �fragmented” controls

De facto liberalization – increased capital flows�

onduct �

2 = aMI+ bES+ cKO+ ε

RBI’S RESPONSE