Question
In an open economy with free capital flows, the central
bank canSolution
This situation is described by the "Impossible Trinity" or "Trilemma" in international economics, which states that it is impossible for a country to have all three of the following at the same time: a fixed foreign exchange rate, free capital movement, and an independent monetary policy. In an open economy with free capital flows, the central bank can either stabilize the exchange rate or set the interest rate, but it cannot do both simultaneously. If the central bank tries to set the interest rate, it loses control over the exchange rate, and vice versa.
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