Impossible Trinity: Basics and Facts

I am finding another source of learning apart from textbooks and academic papers- speeches. I am noticing the quality of speeches by policymakers is getting better by the day. So much so, I have put a seperate link in my blog to cover speeches.

Here is another excellent speech (summary is here) by BIS Deputy General Manager, Hervé Hannoun. He discusses impossible trinity and helps understand it by providing case studies of Asian-Pacific nations.

What is Impossible Trinity? Wikipedia explains:

….the hypothesis in international economics that it is not possible to have

• A fixed exchange rate
• Free capital movement
• An independent monetary policy

Suppose a country is growing and in order to grow further would need to  increase its investments. So far, its savings have been enough and now it needs foreign savings as well. As a result, the policymakers liberalise capital flows (inwards and outtwards) in the country. Given this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both. Why?

Now suppose, the country is Japan whose currency is yen (“this is just an example”) and it has both objectives price and exchange rate stability. To achieve former, it maintains fixed exchange rate and for latter, it maintains an inflation target (implicit or explicit).

• As capital inflows are allowed, foreign investors take exposure in Japan and bring their dollars, convert it into yen and invest it.
• As a result the demand for domestic currency goes up. Ideally as demand goes up so should the price meaning exchange rate should appreciate (or go up from Rs 45 per dollar to say 40)
• But as currency is fixed, the Central bank needs to maintain the level and instead gives the foreign borrower the desired yen and keeps the dollars with itself.
• Now, as supply of yen increases in the economy so does inflation (too much money chasing few goods). As inflation stability is also an objective the entire thing comes on its head, hence the impossibility of making all 3 objectives work together.
• Note that higher inflation can also be controlled by sterilizing the flows i.e. Central Banks issue govt. securities and suck the money supply. But that means more expenditure for government and is not a long-term solution as govts are supposed to direct their expenditure towards enhancing capital base of the country and not for monetary and exchange rate stability.

So after some concepts, let us get back to the speech. On Page 4, it has a table that summarises what each Asia-Pacific nation is doing. Some e.g.

Hong Kong, with open capital markets and a currency board, implicitly accepts foreign monetary policy, which can at times be too tight or too easy. The fixed exchange rate provides a stable environment for importers and exporters.

Countries such as Australia and New Zealand have chosen domestic price stability in the form of an inflation target, and accept a high degree of exchange rate volatility.

India has a multiple indicators approach and looks at everything.

As surging capital flows is a problem with most, he goes on to discuss the possible solutions to contriol the situation which are straight from textbook:

1. Allow curreny to appreciate
2. Intervene to prevent appreciation
3. Impose retrictions on capital flows

Then he cites evidence that Asian countries generally have been reluctant to let their country appreciate. Meaning given the two choices after allowing for capital flows , they have preferred to keep exchange rates stable and have not allowed them to appreciate.

Countries like Korea, NZ and Philippines have inflation targets and capital flows have been a problem with them. Ideally we should have seen some appreciation in these countries.

Now, see the table on Page 10. It shows currency has appreciated only in India, Korea and China (now, China is a surprise) from 1994 levels.

This is what makes the entire learning so good. You not only know what impossible trinity is, you also know which country is doing what?

The consensus in economic circles is that have free capital inflows, and have a stable monetary policy & let the currency float. His speech also discusses the same and suggests ways in which Asia-Pacific nations can move towards floating/flexible exchange rates.

Super stuff. Highly recommended. 

Update:

I have  written two papers on the subject, one a general overview on Impossible Trinity and two, a specific report on how RBI is managing the Impossible trinity.

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