• Ipek Sanri

The impossible trinity

The impossible trinity or trilemma is a contribution of the Mundell-Fleming framework which is in the context of an open economy extension of the IS-LM Neo-Keynesian model. The trilemma implies that these three policies: financial mobility, exchange rate stability, and monetary independence, cannot be achieved simultaneously in a small economy. Figure 1 summarizes the impossible trinity.

Assume that a country aims for free financial mobility under a fixed exchange rate regime.

Free capital mobility implies domestic assets are perfect substitutes for foreign assets; hence, domestic and foreign interest rates are equal. If the central bank implements an expansionary monetary policy and increases the money supply, the pressure on the domestic interest rate to decrease causes a sale of domestic bonds. As a result, an excess foreign currency demand occurs and pressurizes domestic currency to depreciate. However, under a fixed exchange rate regime, the central bank should intervene to avoid depreciation. Thus, the central bank sells foreign currency to the public to discard the excess supply of domestic currency. At first, the central bank increases the money supply and then decreases it by selling foreign currency (or buying domestic currency). So, the monetary policy of the central bank is useless in this context. Perfect capital mobility under a fixed exchange rate regime implies giving up monetary policy. In the 1990s, this was preferred by developing countries. For example, Argentina implemented a fixed exchange rate regime through a currency board. The inflation rate decreased to 1% and real output per capita grew at an annual average rate of 4.6% from 1992 to 1998. However, a fixed exchange rate does not provide complete protection from speculative attacks on the currency or shocks such as export shortfall. In the Argentina case, the budget deficit increased drastically, and Brazil's financial crisis contributed to Argentina’s problems. As a result, it experienced a recession, tax revenues fell and caused a deepening in the budget deficit. Without monetary independence, it was hard to get out of the recession. So, in 2002, Argentina dropped the fixed exchange rate regime.

Now, consider a case where a small economy requests perfect capital mobility and monetary independence. It could be done under a flexible exchange rate regime. Assume that the central bank implements an expansionary monetary policy; hence, a decline in domestic interest rates occurs. A capital outflow occurs in search of a higher foreign yield. This causes a depreciation of the domestic currency. Monetary policy is effective in this case because through a reduction in interest rates, domestic investments increase due to a decline in cost of borrowing, and net exports increase assuming that the Marshall-Lerner condition holds, which implies a domestic currency depreciation causes an increase in exports because domestic goods are relatively cheaper now. This has been preferred by the U.S. during the last three decades.

Finally, assume that a small economy wishes monetary independence under a fixed exchange rate regime. In this scenario, financial integration is dropped; hence, domestic and foreign interest rates are not equal necessarily. The short-term capital movements should be restricted otherwise the capital flows pressure the domestic currency, depending on whether the monetary policy is expansionary or contractionary. To avoid the central bank's act against the currency changes, capital mobility should be controlled. In the mid to late 1980s, most of the developing countries adopted this.

Having covered a brief explanation of what the impossible trinity is, let me now discuss a

highly controversial study. Rey (2015) has written a paper implying that this is not a

trilemma: it is a dilemma. She questioned the scale of globalization and the role of global

banks, and states that “independent monetary policies are possible if and only if the capital

account is managed, directly or indirectly, regardless of the exchange‐rate regime” (2015, s.

21). Due to increased globalization and expansion of financial markets, monetary conditions

are transmitted from the center to the world through credit flows, independent of the exchange rate regime.

There are many studies on this topic. Some scholars support Rey’s argument, some do not. In my opinion, the impossible trinity is a crucial concept in order to understand the IS/LM/BP

model. On the other hand, as future economists, we should continue to follow the ongoing

discussions. Who knows, maybe what we know to be true right now may not always be true.


Aizenman, J. (2010). The Impossible Trinity (aka The Policy Trilemma).

Appleyard, D. J., & Field, A. J. (2014). International Economics. McGraw-Hill Irwin. Retrieved from http://mis.kp.ac.rw/admin/admin_panel/kp_lms/files/digital/SelectiveBooks/Economics/International%20Economics%20(8th%20Ed)(gnv64).pdf

Cömert, H. (2019). From trilemma to dilemma: monetary policy after the Bretton Woods world. In Finance, Growth and Inequality. Edward Elgar Publishing.

Rey, H. (2015, May). Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy

Independence. National Bureau of Economic Research. NBER Working Paper.


Schoenmaker, D. (2011). The Financial Trilemma. Economics Letters, 111(1), 57-59.doi:10.1016/j.econlet.2011.01.010