The Impossible Trinity - Krugman

Introduction

The impossible trinity, also known as the trilemma, is a concept in international economics that states that countries cannot simultaneously have a fixed foreign exchange rate, free capital movement and an independent monetary policy. This trilemma was first introduced by the economist Robert Mundell in the 1960s. However, it was Paul Krugman, another Nobel laureate in economics, who refined the idea and made it famous. In this article, we will explore the \"impossible triangle\" and Krugman's interpretation of its implications.

The Three Components of the Impossible Trinity

The three corners of the impossible trinity are:

• Fixed exchange rates
• Free movement of capital
• Independent monetary policy

Fixed exchange rates mean that a country's currency is pegged to another currency or a basket of currencies, and its value is fixed. Free movement of capital means that individuals and firms can move their money across borders without any restriction. Independent monetary policy means that a country's central bank is free to set its own interest rates, adjust its money supply and implement other monetary policies without having to coordinate with other central banks.

The Trade-offs

The impossible trinity suggests that countries can achieve any two of the three policy goals but not all three. For instance, if a country wants to maintain a fixed exchange rate and free movement of capital, it has to give up its ability to set its own monetary policy. This is because a fixed exchange rate requires the central bank to maintain a certain level of foreign reserves to support the fixed exchange rate. To do so, the central bank has to buy and sell currency in the foreign exchange market, which can lead to a change in the domestic money supply and interest rates. If the capital is free to flow in and out of the country, the central bank may not be able to control the money supply and interest rates. On the other hand, if a country wants to have an independent monetary policy and free movement of capital, it has to give up its fixed exchange rate. This is because a country with a fixed exchange rate has to adjust its interest rates to match those of the country to which its currency is pegged. If the central bank wants to set a different interest rate to achieve its domestic policy goals, it would have to abandon the fixed exchange rate. Finally, if a country wants to maintain a fixed exchange rate and an independent monetary policy, it has to restrict the movement of capital. This is because a fixed exchange rate requires the central bank to have enough foreign reserves to maintain the peg. If capital is free to flow in and out of the country, it can quickly deplete the foreign reserves, and the central bank would have to abandon either the fixed exchange rate or its monetary policy autonomy.

Krugman's View

Krugman, being a critic of unfettered globalization and a supporter of the use of monetary policy to manage the economy, believes that the impossible trinity is not impossible but instead a choice. He argues that countries can have two-and-a-half of the three goals if they are willing to accept a small amount of inflation. This means that countries can maintain a fixed exchange rate and an independent monetary policy but may have to accept some restrictions on capital flows. Alternatively, countries can have free movement of capital and an independent monetary policy but may have to accept some fluctuations in the exchange rate. Krugman also notes that the impossible trinity is a useful framework for understanding the costs and benefits of different policy choices and that the policy trade-offs can change over time depending on economic and political conditions.