International Finance — The Impossible Trinity and Exchange-Rate Regimes

International Finance — One of the Three Has to Go

The Mundell–Fleming model of chapter 3 already implies the trilemma. If capital moves freely and the exchange rate is fixed, the domestic interest rate is tied to $r^*$, and the central bank becomes the counterparty to the foreign-exchange trades that defend the rate. There is no independent interest rate for prices and the business cycle.

1. The central bank balance sheet reveals the constraint

Under a fixed rate, when investors sell domestic assets and buy foreign currency, the central bank pays out foreign reserves and withdraws base money. When reserves run out, the peg breaks. Conversely, when inflows pour in, base money grows, and there are limits to offsetting it by selling domestic assets (sterilization).

Bretton Woods kept room for domestic policy through capital controls and fixed rates. Since the 1990s, many countries have opened to capital flows and wavered between floating rates and de facto dollar pegs. The European single currency is a choice of fixed exchange rates and capital mobility at the cost of member states’ independent interest rates.

2. Intermediate regimes leave a target for attack

Bands, crawling pegs and managed floats signal to the market that “we will defend up to a certain line”. If that line is not credible, attacks aim at it. First-generation crisis models hold that when expansionary fiscal or monetary policy clashes with a fixed rate, a speculative attack comes earlier than the point at which reserves would run out on their own. The second generation stresses self-fulfilling expectations that the government will give up when the cost of defence (rate hikes, recession) grows. The third generation adds firms’ and banks’ foreign-currency debt and deteriorating balance sheets as a channel.

If the top of a won/dollar band is 1,400 won and reserves are visibly falling, the cost of betting on a break above 1,400 is limited and the payoff large. Defending with a sharp rate hike freezes domestic credit. That trade-off, visible to attackers, is the crisis pressure.

3. The boundary with the financial-crisis chapter

Bank leverage and the amplification of bank runs are covered in financial economics chapter 5. This chapter focuses on how an exchange-rate commitment becomes the trigger of that amplification. With large foreign-currency debt, depreciation itself creates a net-worth shock. That is why “just choose a floating rate” is not free within the trilemma.

Check your understanding

What happens if a small country with free capital mobility keeps its exchange rate fixed and raises its interest rate above the world rate to curb domestic inflation? Capital inflows create appreciation pressure, and defending the peg requires expanding base money, which offsets the tightening. Trying to keep all three does not last.

References

• Maurice Obstfeld, Jay Shambaugh and Alan Taylor, “The Trilemma in History,” Review of Economics and Statistics (2005)
• IMF, Annual Report on Exchange Arrangements and Exchange Restrictions
• Bank of Korea, Foreign reserves statistics (Korean)