CFA Level I · CFA Level I Exam · Capital Flows and the FX Market
A country fixes its exchange rate and allows free capital mobility. According to the impossible trinity, the country most likely must:
The country must give up independent monetary policy. With a fixed rate and free capital mobility, domestic interest rates must follow those of the anchor country to prevent capital flows from breaking the peg. Only two of the three policy goals can be achieved at once.
- Aabandon an independent monetary policyCorrect
- Bimpose controls on all trade in goods
- Cmaintain a floating exchange rate
Explanation
The impossible trinity states a country cannot simultaneously have a fixed exchange rate, free capital flows and independent monetary policy. With the first two chosen, monetary policy must be subordinated to maintaining the peg. Trade controls are irrelevant, and floating would violate the stated fixed rate.
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