IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates
A country's central bank pegs its currency to a larger economy's currency and allows free capital movement. According to the 'impossible trinity' (policy trilemma), which of the following must it give up?
It must give up independent monetary policy. The trilemma allows only two of three: a fixed exchange rate, free capital movement and monetary autonomy. With a peg and open capital flows, domestic interest rates must track the anchor country's rates.
- AIndependent monetary policyCorrect
- BA stable exchange rate
- CFree capital mobility, in addition to the peg
- DForeign exchange reserves
- The ability to levy taxes
Explanation
The trilemma says a country can have only two of three: fixed exchange rate, free capital movement, and independent monetary policy. Having chosen a peg and open capital flows, it loses independent monetary policy, as domestic rates must follow the anchor country's to avoid capital flight.
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