Saw the Michael Pettis/Kyle Bass interview this morning and almost instantly felt like I was back in grad school! They mentioned the Impossible Trinity and it got me thinking about our Exchange here...
As individuals who observe the FX markets for one reason or another, understanding capital flows and the relationship they have with interest rates and exchange rates is absolutely fundamental.
How many of you remember the Mundell-Fleming Trillema, also referred to as the Impossible Trinity?
Here is a quick recap: Lets imagine you run a country. Ideally, you’d like to keep the exchange rate stable so that import/export prices aren’t all over the place. Second, it would be nice to control interest rates so that you can appease both savers and borrowers. Lastly, it would be perfect if money could flow in and out of your country without too much friction.
The issue is you can’t do all 3. Why? Simple- Here is 1 scenario: If you lowered interest rates in your country in the hope of boosting domestic investment and lowering unemployment, there is a good chance capital will flow out in search of higher yields. This in turn would cause your exchange rate to fall which theoretically would create inflation. Under such circumstances you’d be forced to raise interest rates again. See the problem?
Here is the breakdown of your choices. (Most countries have gone with option B.)
- A = Fixed exchange rate + free capital mobility
- B = Free capital mobility + monetary autonomy... (More)