The Triangle Of Impossibility In Macroeconomics

Researchers have said that only two of these issues - monetary policy independence, free capital movement and foreign exchange flexibility can be dealt with at the same time.

For many years, the discussion on alternative exchange rate regimes has been ruled by the so-called “triangle of impossibility” (also “impossible trinity” or “unholy trinity”). According to this widely held paradigm, policy makers in an open economy must choose between three policy targets which cannot be achieved simultaneously:

• an independent monetary policy;
• a flexible exchange rate; and,
• free capital movement.
Therefore, if a country wants to avoid restricting capital movements (which is basically impossible), it has to choose between either an independent monetary policy and a flexible exchange rate or a fixed exchange rate and an ineffective monetary policy.

The theoretical foundation for this approach is the Mundell-Fleming model which showed that with free capital mobility, monetary policy is inefficient under fixed rates, while it is fully effective under flexible rates (Mundell, 1963).

In other words, if a country wants to achieve an autonomous interest rate policy (independent monetary policy) and stabilise the exchange rate (fixed exchange rate) at the same time, it has no alternative but to introduce capital controls.

It became obvious after the Asian crisis of 1997-98 that this paradigm of either choosing between fully fixed or freely flexible exchange rates was not sustainable.

Fischer, 2001; Rajan, 2003 and Eichengreen (2001: 267) have put this view as follows:

…high capital mobility has made it exceedingly difficult…to operate pegged but-adjustable exchange rates …Intermediate regimes are fragile. Operating them is tantamount to painting a bull’s eye on the forehead of the central bank governor and telling speculators shoot here.

In reality, however, studies have shown that in the last two decades, many countries have been intervening heavily on foreign exchange markets, but in most cases without declaring fixed target values for the exchange rate of their currency.

This is reflected, above all, by the huge increase of foreign exchange reserves held by emerging market economies.

Of course, most countries do not want to make such policies public. Instead, for the statistics of the IMF they declare to operate a system of flexible exchange rates. This discrepancy was detected at the beginning of the last decade by Calvo and Reinhart (2000) in a paper titled “fear of floating”.

Thus, in contrast to the “hollowing out” hypothesis, many countries are neither willing to peg their currency in a formal way nor to leave the fate of their currency to irrational foreign exchange markets.

In other words, disregarding theory, many countries have tried to cope with the triangle of impossibility in a pragmatic way. However, without a comprehensive theoretical framework such an approach bears the risk to produce inconsistencies which lead to undesired results.

Above all, the Asian crisis in the year 1997 has shown that an exchange rate targeting which is inconsistent with Uncovered Interest Parity (UIP) can attract large short-term capital inflows (hot money). These do not only produce an unwarranted appreciation of the domestic currency, but at the same time also undermine the effectiveness of domestic monetary policy.

However, when managed floating is introduced into the analysis, it can be shown that “inconsistency triangle” can be transformed into a “consistency triangle”. This strategy is based:

• on the theoretical equilibrium condition of UIP according to which the path of a bilateral exchange rate should be identical with the interest rate difference between two currencies; and

• on the famous Tinbergen principle according to which the number of policy instruments corresponds with the number of policy targets.As the Mundell-Fleming model shows, in an open economy there are two targets: external and internal equilibrium. For these two targets, two instruments are needed. In an open economy, a central bank has control over two instruments that can be targeted directly and combined in different ways:

• Interventions in the domestic money market in order to control the short-term interest rate as its policy rate. The effects of money market interventions are reflected in changes of the monetary base.

• Sterilised interventions in the foreign exchange market in order to target the exchange rate. The effects of these interventions are reflected in changes of the stock of foreign reserves. Interventions on the foreign exchange market have an immediate impact on the monetary base, but this effect can be sterilised by a compensating adjustment of domestic positions of the central bank’s balance sheet.

For the strategy of managed floating, the target of external equilibrium is defined according to the UIP condition as a constellation where the positive (negative) difference between the domestic interest rate and the interest rate of a pivot currency is identical with the target value for the depreciation (appreciation) of the domestic currency against the pivot currency.

As the foreign interest rate is exogenous and the domestic interest rate is determined by the target of internal equilibrium, the UIP condition determines the target path of the nominal exchange rate. Thus, in this context external equilibrium is defined as a situation where financial markets are in equilibrium over the medium term a UIP path is identical with a PPP path so that it also helps to maintain an external equilibrium on goods markets.

In sum, the strategy of managed floating is characterised by the following policy assignment:

• Internal equilibrium which is compatible with inflation targeting, is achieved with the domestic short-term interest rate; and

• External equilibrium which is defined as a UIP path of the exchange rate vis-à-vis a pivot currency, is achieved by targeting the exchange rate with interventions on the foreign exchange market.

For example, there are four variants of inflation targeting in an open economy. In the first three variants, the interest rate is used as operating target, in the fourth variant the exchange rate serves as operating target:

• Plain vanilla inflation targeting: the exchange rate does not appear explicitly in the policy reaction function.

• Open-economy inflation targeting: the exchange rate is included in the reaction function so that the interest rate is adjusted systematically in response to exchange rate movements.

• Inflation targeting with an exchange rate band: within a predefined exchange rate band this approach is identical with open-economy inflation targeting. If the margin of the band is reached, the inflation target is overridden by the exchange rate objective.

• Exchange-rate-based inflation targeting: the exchange rate rather than the interest rate is used as the operating target for monetary policy. This approach can be implemented through unsterilised intervention in the foreign exchange market.

In all four versions, the central bank always uses only one operating target. This implies that if the interest rate is used as operating target, the exchange rate can only be targeted indirectly with the interest rate.

According to Freedman and Ötker-Robe (2009), a direct exchange rate targeting is regarded as detrimental for open economy inflation targeting. However, by not using the exchange rate and the interest rate as two simultaneous operating targets a central bank gives up an important degree of freedom.

The writer is an economic consultant and former Assistant Professor of Finance and Economics at Alabama State University, Montgomery, Alabama.

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