A
A country cannot have free trade, a balanced budget, and high employment simultaneously
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B
A country cannot have a fixed exchange rate, independent monetary policy, and free capital mobility simultaneously
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C
A country cannot have low inflation, low unemployment, and high economic growth simultaneously
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D
A country cannot have high savings, high investment, and high consumption simultaneously
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Solution
The "impossible trinity" or "trilemma" is a fundamental concept in international economics that describes the trade-offs faced by policymakers in an open economy. This concept is particularly relevant in the context of the Mundell-Fleming Model, which examines the behaviour of economies under different exchange rate regimes. Components of the Trilemma
- Fixed Exchange Rate:
This implies that a country maintains its currency value at a constant rate against another currency or a basket of currencies. It provides stability in international prices, which can facilitate trade and investment.
- Independent Monetary Policy:
This allows a country to set its interest rates and monetary policy according to its domestic economic conditions. Central banks can adjust interest rates to control inflation, manage unemployment, and influence economic growth.
- Free Capital Mobility:
This means that there are no restrictions on the flow of capital across borders. It allows for the efficient allocation of resources and investments on a global scale. The Trade-offs The trilemma posits that it is impossible for a country to achieve all three of these policy objectives simultaneously. A country can only achieve two of the three, and it must forgo the third. The possible combinations are:
- Fixed Exchange Rate + Free Capital Mobility:
Example: Many European countries before the Euro, pegged their currencies to the Deutsche Mark. Trade-off: Loss of independent monetary policy. The country must adjust its monetary policy to maintain the exchange rate peg, often mirroring the policy of the anchor currency.
- Fixed Exchange Rate + Independent Monetary Policy:
Example: China's exchange rate policy in the early 2000s, pegging the Renminbi to the US Dollar while controlling capital flows. Trade-off: Restricted capital mobility. The country imposes capital controls to manage the balance of payments and maintain monetary policy independence.
- Free Capital Mobility + Independent Monetary Policy:
Example: The United States and many advanced economies today. Trade-off: Floating exchange rate. The exchange rate is determined by market forces, and the country cannot guarantee its value against other currencies.
