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

A country with a fixed exchange rate and free capital mobility has a central bank that wishes to cut domestic interest rates well below world rates to stimulate output. According to the impossible trinity (trilemma), what is the likely outcome?

Capital would flow out to higher-yielding foreign assets, pushing the currency down. To defend the peg the central bank must sell reserves, which cannot continue indefinitely, so it must abandon the peg, restrict capital flows, or give up the rate cut, as the trilemma implies.

  1. ACapital outflows put downward pressure on the currency, forcing the central bank to sell reserves or abandon the pegCorrect
  2. BCapital inflows appreciate the currency and strengthen the peg automatically
  3. CThe central bank can keep the peg and rate cut indefinitely with no reserve loss
  4. DThe current account deficit is eliminated immediately

Explanation

The trilemma states a country cannot simultaneously have a fixed exchange rate, free capital movement, and independent monetary policy. Lower domestic rates cause capital to flow out, depreciating the currency; defending the peg requires selling foreign reserves, which is unsustainable, so one of the three must give.

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