The Impossible Trinity

The concept of the impossible trinity, also known as the trilemma, is explained in this episode of Planet Money. Countries must choose between three heroes: free movement of capital, stable exchange rates, and independent monetary policy. However, only two of these can be chosen at once. If capital moves freely and there is a fixed exchange rate, there can't be an independent monetary policy. If there is capital mobility and monetary autonomy, the fixed exchange rate is sacrificed. Lastly, a fixed currency exchange rate and the ability to set interest rates require restricted capital flow. The impossible trinity shows that it is not possible to have all three heroes, but having two out of three is still favorable. Hello, everyone. This month we're tackling big economic ideas for our series, Planet Money Explains. And on today's show, we're diving into a concept that sounds like a straight out of a sci-fi novel, but is in fact a cornerstone of macroeconomic policy, presenting the impossible trinity, also known as the trilemma. In our tale, there are three heroes, but as in any good story, you can't have them all on your side at the same time. It's the same for countries that must choose between the free movement of capital, the stability of exchange rates, and the independence of their monetary policy. Only two of the three are possible at any one time. Let's take a deeper look at why. Our first hero is capital flowing freely across borders. This means businesses and individuals can invest, borrow, and lend money without restrictions and without causing too much disruption. Next, currency exchange rates, the steady and predictable hero. Keeping the currency stable is important for import and export prices. Then there's our third hero, independent monetary policy. This means the ability of a country's central bank to set rates independently without any domestic or foreign government telling them what to do. But here's the twist in our tale. You can only choose two of these heroes. That's the trilemma. Pick any two, but you'll have to leave the third behind. Why? Well, let's play it out. Suppose you want capital to move freely across borders and you want a fixed exchange rate. In that case, you can't have an independent monetary policy because if you try to change your interest rates, money will flow in or out of your country. This will force you to abandon your fixed exchange rate to maintain economic stability. Now, if you choose the capital mobility and monetary autonomy heroes, you have to let go of the fixed exchange rate because if you're attracting or repelling capital with your interest rate policies, your exchange rate will fluctuate as the market reacts to those moves. Lastly, if you decide on a fixed currency exchange rate and the ability to set your own interest rates, you'll have to restrict capital flow. That's because the free movement of capital would again force you to adjust your interest rates or exchange rates to maintain the inflows and outflows of money. And that would mean giving up one of your chosen heroes. And there you have it, the impossible trinity. You can't have all three, but two out of three isn't so bad either. Next week, we'll tackle another head-scratcher, degrowth, what's behind the radical theory that we should be shrinking rather than growing economies. Till next time.