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Mundell trilemma

Page history last edited by Brian D Butler 11 years, 6 months ago



Mundell Trilemma


see foreign currency trading and capital controls


basically says that a country can not have control of their currency if they want to (a) control their domestic interest rates, and (b) have free flowing capital into and out of the country.


Three parts:


A country basically has to choose 2 out of 3 of the following options. (#1). The first option is for control over their currencies exchange rates. A country might want to have a stable currency (and not one that fluctuates greatly) . This is especially important for countries that have a high percentage of foreign trade (in relation to their GDP) and that want to be able to predict the level of trade from one term to the next.


This is the option that the USA (and Europe, and Japan) have chosen to give up, in an effort to maintain options #2 and #3 (described below). The US has essentially been forced to allow their currency to “float” in the foreign exchange markets and be determined purely by global supply and demand of their currency. The advantage of this system is that it allows you to maintain internal domestic control over your economy (by being able to raise and lower interest rates), and it also allows you to take advantage of the massive movement of global financial capital. The drawback of selecting this free-floating exchange rates system is that you can have a relatively cheap currency one year, and thus a favorable environment for exports, but then have a relatively expensive currency the following year (and a favorable environment for imports). It makes international business difficult to plan from one year to the next because you never know if your products are going to be cheap or expensive on the world markets.



(#2). The second part of the “Mundell trilemma” is domestic macro-economic control. A country might want to have the ability to raise internal interest rates in order to fight inflation, or lower interest rates to promote growth. This ability of the national government to control the rates of growth, unemployment and inflation is critical in countries that have a democracy, and where the elected officials are dependant upon the approval of the population.


This is the one option that Argentina chose to give up in 1991 when they pegged their currency to the US dollar. By choosing both option #1 (fixed exchange rates) and option #3 (free mobility of capital), the Argentineans were forced to give up on option #2 (domestic control over interest rates, inflation, and economic growth). The benefit of choosing this option (as Argentina did) is that if a country has a track record of internal corruption, and therefore has a bad reputation among the global financial traders, they might have a difficult time attracting foreign capital (because investors are afraid of corruption, inflation, and so on). But, by tying their currency to a “hard currency” such as the USD, it allows a country to gain instant credibility in macroeconomic management.


The major drawback of this system is that a country loses the ability to raise or lower internal interest rates. Because a country has tied their currency to another “hard currency” such as the USD, then the country must keep their interest rates in line with those of the USA, for example. If there is a divergence in rate, then traders could step in and take advantage of the arbitrage (buying in one country, and selling in another to profit the difference). The global financial markets are too powerful to try and fight, so in the end, the county with the pegged currency is forced to follow the interest rate lead of the hard currency. But, what happens if country with the peg needs to lower interest rates in order to spur growth? They can’t. What if they want to raise interest rates to cut inflation? They can’t.


(#3). The third option is to have international capital mobility. Some countries will find it essential that they have access to global financial capital flows. The USA and Japan for example, are very dependent upon the free flow of capital in and out of their countries in order to finance from and invest abroad (and maintain their large balance of payments). During the Bretton Woods years (1947-71), the US had a different system in that they had selected to maintain #1 (fixed exchange rates), and option #2 (control over domestic policies such as interest rates), but chose to abandon the principle #3 (free flowing international capital). In fact, the entire world chose to limit the flow of international capital for fear of repeating the same dangerous mix that had occurred in lead up to the war.  see capital controls


Even today, there are many countries that would like to limit or control the flow of financial capital into and especially out of their country. Thailand recently attempted to instill financial controls. Why? Well, because the county is alarmed with the level and speed with which financial capital can leave their countries, and leaving a financial crisis in its wake. Many countries are alarmed with the level of speculation that occurs in the global FX market, and they would like to have a way to limit their exposure to the speculative risk. The problem is that in order to protect themselves fro the quick movement of financial capital, they must first be willing to give up on either (#1) a fixed and stable exchange rate, or (#2) the domestic control of their international interest rates.







How the Mundell Trilemma effect currency trading?


It relates to the forward exchange rate / futures contracts.  If a country is going to have interest rates that are different, then they must allow the forward contract to have appreciation/ depreciation to prevent arbitrage.  (as long as money is free to flow into / out of the country).















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