Impossible trinity
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I am currently taking a class with professor Mundell and he has repeatedly disputed that the unholy trinity had anything to do with him! In fact he asserts that it should be called the unholy duality. A country cannot have both: An independet monetary policy and a fixed exchange rate (nothing more needs to be said about free capital movements!)
The Impossible Trinity (or Inconsistent Trinity or Triangle of Impossibility or Unholy Trinity) is the hypothesis in international economics that it is not possible to have
- A fixed exchange rate
- Free capital movement
- An independent monetary policy.
Quoting from a Slate [1] tribute to Robert Mundell written by Paul Krugman in October 1999:
- "[...] The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession (like Argentina today, or for that matter most of Europe)."
The formal model for this hypothesis is the Mundell-Fleming model developed in the 60s by Robert Mundell and Marcus Fleming. The idea of the impossible trinity went from theoretical curiosity to becoming the foundation of open economy macroeconomics in the 1980s, by which time capital controls had broken down in many countries, and conflicts were visible between pegged exchange rates and monetary policy autonomy. While one version of the impossible trinity is focused on the extreme case - with a perfectly fixed exchange rate, with a perfectly open capital account, a country has absolutely no say on monetary policy. But the real world has thrown up repeated examples where when the capital account becomes fairly open, the greater the exchange rate rigidity, the lower the monetary policy autonomy.
In the modern world, given the growth of trade in goods and services, capital controls are easily evaded. In addition, capital controls introduce numerous distortions. Hence, there is virtually no important country which has an effective system of capital control. Under these conditions, the impossible trinity asserts that a country has to choose between reducing currency volatility, or running a stabilising monetary policy. It cannot have both.
