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Gwil91

In economics, what is the impossible trinity?

BAY:

The Impossible Trinity (also known as the Inconsistent Trinity, Triangle of Impossibility or Unholy Trinity) is the hypothesis in international economics that it is impossible to have all three of the following at the same time:
1. A fixed exchange rate
2. Free capital movement
3. An independent monetary policy.
See http://en.wikipedia.org/wiki/Impossible_trinity

Sequoia:

Suppose a country is growing and in order to grow further would need to increase its investments. So far, its savings have been enough and now it needs foreign savings as well. As a result, the policymakers liberalise capital flows (inwards and outtwards) in the country. Given this choice, the hypothesis says the country can either look at exchange rate stability or price stability but not both. Why?
Now suppose, the country is Japan whose currency is yen (”this is just an example”) and it has both objectives price and exchange rate stability. To achieve former, it maintains fixed exchange rate and for latter, it maintains an inflation target (implicit or explicit).
As capital inflows are allowed, foreign investors take exposure in Japan and bring their dollars, convert it into yen and invest it.
As a result the demand for domestic currency goes up. Ideally as demand goes up so should the price meaning exchange rate should appreciate (or go up from Rs 45 per dollar to say 40)
But as currency is fixed, the Central bank needs to maintain the level and instead gives the foreign borrower the desired yen and keeps the dollars with itself.
Now, as supply of yen increases in the economy so does inflation (too much money chasing few goods). As inflation stability is also an objective the entire thing comes on its head, hence the impossibility of making all 3 objectives work together!

Mornay:

The impossibility of combining all three of the following: monetary independence, exchange rate stability, and full financial market integration.

Answer:
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