impossible trinity for dummies
TRANSCRIPT
FIXED EXCHANGE RATE A currency’s value is fixed against the value of another single currency
Used to stabilize the value of a currency against the currency it is pegged to
Makes trade and investments between the two currency areas easier and more predictable
Reduces volatility and fluctuations in relative prices
Eliminates exchange rate risk by reducing the associated uncertainty
Useful for small economies
FREE CAPITAL MOVEMENT Freedom to move money to other countries and invest easily
Governments want to make easy for companies to invest in their country, setting up factories and employing people
Making global movement as easy as possible, money can move to the places where it is needed the most and can make the best return
INDEPENDENT MONETARY POLICY
Control over interest rates
Adjusted to suit the specific needs of the economy
If the economy is in a recession or a slow down, interest rates can be lowered to give the economy a boost.
If the economy is overheating or in a bubble with too high inflation, interest rates can be raised
WELCOME TO MICKEY-LANDA prosperous land with rich natural resources
Central Bank Governor of MickeyLand learns of the
Impossible Trinity.
‘MICKEYLAND’ WANTS ECONOMIC GROWTH – (Scene 1)
The of Mickey-Land is worried about the
recent Economic Slowdown
He decides to encourage all kinds of business in Mickey-
Land by giving loans at Low Interest Rates
Mickey Dollars are easily available
Businesses are growing
MICKEY $ IN TROUBLE (Scene 2)Mickey Dollars are now easily
available in MickeyLand. Enter Uncle Scrooge (U.S)
Rich Uncle Scrooge(U.S) now sees no incentive in keeping
his money in MickeyLand, since Interest Rates are low
Duckling 1(from Nigeria) offers much better Interest Rates. Uncle Scrooge(U.S) shifts money to Nigeria
NOTE : This is because MickeyLand ALLOWS FREE FLOW OF CAPITAL.
BACK IN MICKEYLAND(Scene 3)There is a shortage of Uncle
Scrooge $ in MickeyLand and Mickeyland $ value depreciates in
the World Market
MickeyLand wanted FIXED EXCHANGE RATE, and it
‘buys back’ Uncle Scrooge $, increasing demand for it.
Large amounts of MickeyLand $ are needed to convince Uncle
Scrooge! This reduces liquidity in MickeyLand $
Liquidity reduces Interest Rates Rise!
WHAT IF…..(Scene 4)MickeyLand decided that they can
control everything by imposing Capital Controls
Uncle Scrooge is prohibited from Capital Transfer into Nigeria
However there is Mr. UnniKrishnan (UK), who wants to
invest in MickeyLand but is a victim of the Prohibition
Capital Flow Controls cause fluctuations in Import and Export
and MickeyLand suffers.
IN A NUTSHELL……. If interest rates were lowered to boost the economy, capital would leave the country to get a
better return
Asian Financial Crisis: Trinity explained
Marked by Fixed exchange rates, Free Capital Flows and High Interest rates
Growth of economic bubble fueled by hot money which was expensive, high short term interest rates
Large private current account deficits led to higher debts to GDP
External shocks culminated in increase of US interest rates which led to outflow of capital
Raise of US dollar made the pegged currencies strong and less competitive in global markets, higher Current Account deficit
Governments in return increased interest rates. Reserves couldn’t sustain it and led to floating
Aftereffects: This led much of the developing world to abandon fixed exchange rates
The western institutions no more frown modest capital controls
Asian countries built up large reserves as contingency for future
INDIAN SCENARIO Gradual financial liberalization, first domestic, then foreign
More market-determined exchange rate system and current account convertibility�
Slow and incomplete capital account liberalization: “Complex, discretionary and �fragmented” controls
De facto liberalization – increased capital flows�
onduct �