The Trilemma under Any Fixed Exchange Rate Regime
The trilemma is a three-faceted dilemma faced by small and open economies under any fixed exchange rate regime. (A small economy is an economy that cannot influence the world interest rate. An open economy allows international trade, as well as international flows of capital.) This concept shows the limits on economic policy under a commodity standard.
The trilemma implies that, under the fixed exchange rate regime, the simultaneous implementation of the following three items isn’t possible:
Free capital flows
It means that all three items cannot be manipulated simultaneously by the government and a government can choose at most two of these three items.
Suppose the government wants to determine all three items independently. In other words, a country aims to maintain the internal and external balance while opening the country to free capital flows. If the country implements an expansionary monetary policy in an attempt to increase output and employment, the increase in the money supply decreases the domestic interest rate.
Because the country doesn’t have any capital controls, both domestic and foreign investors move funds abroad to receive higher interest rates in other countries. They would sell domestic currency in exchange for foreign currency, which would devalue the domestic currency.
To prevent the currency from devaluating, and to maintain the fixed exchange rate, the central bank intervenes in the foreign exchange market by selling some of its foreign currency reserves to buy its own currency.
If the government continues in its expansionary monetary policy, investors will also continue to move funds out of the country and the central bank’s foreign exchange reserves will eventually be exhausted. This is a speculative attack, or a run on a currency. At the end, the fixed exchange rate is broken, and a large devaluation of the domestic currency follows.
Okay, so all three items can’t be simultaneously possible. You can pick any two from the previous list and think about what you can accomplish and what you need to let go. For example, if you want to focus on maintaining internal and external balance, you need to implement some capital controls. Otherwise, whenever you implement a monetary policy change, it will end up pressuring the fixed exchange rate to change.
If you prefer maintaining external balance and free capital movement, then internal balance (full employment with price stability) can’t be achieved through domestic monetary policies. In this case, you need to revamp the country’s fiscal policy framework.
If you keep internal balance and free capital movement, and forgo external balance (in other words, the fixed exchange rate), this system becomes a lot like the current flexible exchange rate system. You can use monetary policy to your heart’s content to address the domestic economic situation of the country and allow international capital movements, which changes the exchange rate.
Under flexible exchange rates, an expansionary and contractionary monetary policy leads to the depreciation and appreciation of the currency, respectively.