Trilemma

DEFINITION of 'Trilemma'

The impossible trinity, also called the Mundell-Fleming trilemma or simply the trilemma, expresses the limited options available to countries in setting monetary policy. According to this theory, a country cannot achieve the free flow of capital, a fixed exchange rate and independent monetary policy simultaneously. By pursuing any two of these options, it necessarily closes off the third. 

BREAKING DOWN 'Trilemma'

The idea of the policy trilemma is frequently credited to the economists Robert Mundell and Marcus Fleming, who independently described the relationships among exchange rates, capital flows and monetary policy in the 1960s. Maurice Obstfeld, who became chief economist at the IMF in 2015, presented the model they developed as a "trilemma" in a 1997 paper. 

According to the trilemma model, a country has three options. It can

set a fixed exchange rate between its currency and another while allowing capital to flow freely across its borders,

allow capital to flow freely and set its own monetary policy, or

set its own monetary policy and maintain a fixed exchange rate.

It cannot, however, fix exchange rates, allow capital to flow freely and maintain monetary policy sovereignty. To see why, imagine this scenario. Country X links its currency, the X pound, to the Y franc at a one-to-one ratio. That works as long as both Country X and Country Y's central banks maintain a policy rate of 3%. But if Country Y raises interest rates to combat rising inflation, investors would spot an opportunity for arbitrage. X pounds would flood over the border to buy Y francs and earn the higher interest rate.

Y francs would in effect become worth more than X pounds, and something would have to give. Either Country X abandons the currency peg and allows the X pound to fall; or it raises its policy rate to match Country Y's, abandoning monetary policy independence; or it sets up capital controls to keep X pounds in the country.

Real-world examples of these trade-offs include the eurozone, where countries have opted for side A of the triangle: they forfeit monetary policy control to the European Central Bank, but maintain a single currency (in effect a one-to-one peg coupled with free capital flow). The difficulties of maintaining a monetary union across economies as different as Germany and Greece have become clear as the latter has repeatedly appeared poised to drop out of the currency bloc

Following World War II, the rich world more or less opted for side C under the Bretton Woods system, which pegged currencies to the dollar but allowed them to set their own interest rates. Cross-border capital flows were so small that the system held for a couple of decades – the exception being Mundell's native Canada, a situation which the Economist argues gave him special insight into the tensions inherent in the system. Today most countries allow their currencies to float, meaning they opt for side B.

The French economist Hélène Rey has argued that the trilemma is not as simple as it appears, since most countries lack monetary policy independence whether or not they have free exchange rates and capital flows. The reason has to do with the overwhelming influence of the Federal Reserve