Impossible Trinity
AdvancedThe impossible trinity is the principle that a country cannot have all three of the following at the same time: a fixed exchange rate, free movement of capital across its borders, and an independent monetary policy.
The idea, also called the trilemma, comes from work by economists Robert Mundell and Marcus Fleming in the 1960s. A country can choose any two of the three goals, but not all three.
With a fixed exchange rate and free capital movement, a country must follow the interest rates of the country it is pegged to, otherwise money would flow in or out and break the peg. Hong Kong, which pegs its dollar to the US dollar and allows free capital flows, broadly follows US interest rates.
With free capital movement and an independent monetary policy, the country must let its exchange rate float, as the United States, the euro area and the United Kingdom do.
With a fixed exchange rate and independent monetary policy, the country must restrict capital flows, as China has done to a significant extent.
The trinity helps explain why countries choose different exchange rate systems and why some currency pegs have collapsed when countries tried to pursue all three goals at once.
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