The Open Economy Trilemma and Exchange Rate Regimes

In this final chapter, we have, among others, discussed what investors do in a carry trade, when they have the option to invest in either their home country or abroad. An investor who is faced with earning say 10% interest at home and say 8% interest abroad will choose the former if the exchange rate of the home country’s currency appreciates or is zero. Central banks or monetary authorities encounter three monetary policy options in international finance, namely: (1) pegged exchange rates, (2) free flow of funds, and (3) monetary policy autonomy. These three policy options cannot be implemented simultaneously by any central bank. Hence, the three policy options are referred to as the impossibility trinity or simply as trilemma. Only two of the said policy options can be implemented simultaneously. They are (a) pegged exchange rate and monetary policy autonomy; (b) pegged exchange rate and free flow of funds (or perfect capital mobility); and (c) monetary policy autonomy and free flow of funds. Option (a) is adhered to by China; it requires capital control. Option (b) is adhered to by European union it requires monetary discipline which is provided by the European Central Bank (former Bundesbank) which is head-quartered in Frankfurt. Option (c) is adhered to by most of the rest of the world countries. It requires either free or managed floating exchange rates. Both flexible and fixed exchange rate regimes have been discussed in this chapter. We have also discussed at length all variants of fixed exchange rates, namely: (i) inflation targeting, (ii) dollarization, (iii) currency or monetary union, (iv) exchange rate targeting, and (v) currency-board, We have also provided (a) illustrative examples, (b) features of some of the above variants, and (c) their advantages and disadvantages We have discussed optimum currency areas, and covered both types of currency areas, namely: international currency area and interregional currency area. We have provided illustrative examples to explain adjustment process in an international currency area with a fixed exchange rate, when there is decline in demand for goods and services from one member to another member, when both members belong to the same international currency areas, where there are several currencies.