Question

Each country has a choice of - a. Allowing free flow of capital, b. Setting a...

Each country has a choice of - a. Allowing free flow of capital, b. Setting a Fixed Exchange rate c. Having control of its domestic monetary policy. Each country faces a trilemma. Any country can choose only 2 of the 3 policy choices, it has to accept the third one. Explain clearly why a country faces this choice. Choose any 2 and explain why the third one falls in place?

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Answer #1

The combination of open capital account, fixed exchange rate & independent Monetary policy , is an impossible Trinity, is not feasible.

A country can attain any two of the 3 objectives , but not all three simultaneously, so for example with open capital account , & fixed exchange rate, a country has to intervene to manage it's monetary policy, that is managed floating, hence independent Monetary policy not feasible.

Also if a nation opens its capital account, allowing free flow of capital , then to have independent domestic monetary policy, floating exchange rate system is needed.

Bcoz due to appreciation & depreciation caused by free flow of capital, fixed exchange rate system is not feasible .

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