Our previous post looked at the reasons for Singapore’s decision to choose a managed exchange rate and free capital flows over a sovereign monetary policy. However, we received questions about why it is impossible to achieve the 3 conditions below and thus we’re attempting to give you a brief understanding of the theory.
Let’s assume hypothetically that USA attempts to have all 3 of the following economic options at its disposal. Let’s say the government is experiencing a downturn in the business cycle. Given that the government has a sovereign monetary policy at its disposal, it will attempt to stimulate the economy by using expansionary monetary policy.
Thus, the central bank will intervene to increase the money supply through possibly open market operations – purchasing of government bonds or affecting the liquidity ratio. This reduces interest rates, achieving the purpose of reducing the cost of borrowing thus increasing investment through higher expected rate-of-return and consumption on big ticket items.
However, since interest rates has decreased as compared to the world and the country allows FREE CAPITAL FLOW, investors have an incentive to shift their capital from USA into other countries with higher interest rates. In economic terms, hot money flows out of the country. As investors exchange USD for foreign currency, the supply of USD increases in the forex market which places depreciation pressure on the USD. (Recall that exchange rate markets can be thought of just like other goods market with a demand and supply graph, as supply increases, price of USD in terms of foreign currency decreases)
Now, for the country to control exchange rates, the central bank will have to intervene in the forex market to appreciate the currency. It will use its foreign reserves to intervene in the market, purchasing USD from the forex market with foreign currency. This has the effect of decreasing the supply of USD in the forex market. However, by reducing the supply of USD, effectively, it is also a reduction of the money supply (which would cause interest rates to increase) and this is in contrary to the purpose that the central bank wanted to achieve at the beginning to acquire an expansionary monetary policy.
The result is that as the money supply decreases, interest rate return to the original equilibrium. The central bank and government failed to achieve its original purpose and merely allowed investors to benefit from carry trade.
At this point, you finally witness how impossible it is to achieve all 3 conditions in the impossible trinity. Empirical evidence based on historical backgrounds have proven that any attempts to break the impossible trinity (open economy trilemma) often lands in disaster.