IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates
A small economy pegs its currency to the dollar, allows free capital movement and wants to keep an independent monetary policy. According to the impossible trinity (policy trilemma), what is the outcome?
The trilemma says only two of three goals, namely a fixed exchange rate, free capital mobility and independent monetary policy, can be held together. A country seeking all three must abandon at least one, regardless of reserve size or inflation level.
- AAll three objectives can be achieved simultaneously if reserves are large enough
- BIt can achieve these three objectives provided inflation is low
- CThe three objectives are only incompatible under a floating rate
- DIt must give up at least one of the three objectives, because only two of fixed exchange rate, free capital mobility and independent monetary policy can be held togetherCorrect
- It must give up the fixed rate only, as the other two are always compatible
Explanation
The trilemma states that a country can pursue only two of the three: a fixed exchange rate, free capital mobility and independent monetary policy. The country described wants all three, so at least one must be given up. Reserves or low inflation do not remove the conflict, and which one is dropped is a policy choice.
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