Question

What is the difference between Floating and Fixed Exchange Rates? Why does the impossible trinity not hold? Give an example.

Answer 1

A fixed exchange rate denotes a nominal exchange rate that is set firmly by the monetary authority with respect to a foreign currency or a basket of foreign currencies. By contrast, a floating exchange rate is determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.

The impossible trinity does not hold because it is not possible to have a fixed (or highly managed) exchange rate, monetary policy autonomy, and open capital markets.” According to it, a stable exchange rate without capital controls requires domestic and foreign interest rates to be equal.