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FRM Part I · FRM Exam Part I · Foreign Exchange Markets

A country maintains a fixed exchange rate and free capital mobility. Domestic interest rates are lowered by the central bank to stimulate growth, and investors expect the peg to hold. According to the impossible trinity (trilemma), what is the most likely consequence?

Capital outflows would pressure the currency, forcing the central bank to sell reserves or reverse the rate cut. The trilemma says a fixed rate, free capital mobility and independent monetary policy cannot coexist, so lowering rates below foreign rates undermines the peg.

  1. ACapital outflows put pressure on the currency, forcing the central bank to sell reserves or reverse the rate cut, since independent monetary policy is incompatible with the other two goalsCorrect
  2. BThe fixed rate is maintained with no cost, since the trilemma allows all three objectives
  3. CCapital inflows increase and the currency appreciates beyond the peg
  4. DThe current account moves immediately into surplus

Explanation

The trilemma states a country cannot simultaneously have a fixed exchange rate, free capital movement and independent monetary policy. Lowering rates below foreign rates triggers outflows and depreciation pressure on the peg. The central bank must sell reserves, which tightens liquidity, or abandon the rate cut or the peg. Inflows and appreciation would follow from raising rates, not cutting.

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