CRF Blog

The Mundell-Fleming trilemma

by David De La Torre

The Economist has published six articles on seminal ideas in economics. The sixth article is on The Mundell-Fleming trilemma, which says that a country may choose only two of three options in monetary policy.

The policy trilemma, also known as the impossible or inconsistent trinity, says a country must choose between free capital mobility, exchange-rate management and monetary autonomy …. Only two of the three are possible. A country that wants to fix the value of its currency and have an interest-rate policy that is free from outside influence (side C of the triangle) cannot allow capital to flow freely across its borders. If the exchange rate is fixed but the country is open to cross-border capital flows, it cannot have an independent monetary policy (side A). And if a country chooses free capital mobility and wants monetary autonomy, it has to allow its currency to float (side B).

To understand the trilemma, imagine a country that fixes its exchange rate against the US dollar and is also open to foreign capital. If its central bank sets interest rates above those set by the Federal Reserve, foreign capital in search of higher returns would flood in. These inflows would raise demand for the local currency; eventually the peg with the dollar would break. If interest rates are kept below those in America, capital would leave the country and the currency would fall. [more]

The other articles can be found here:

George Akerlof’s 1970 paper, “The Market for Lemons”

Minsky’s moment

The Stolper-Samuelson theorem

Fiscal stimulus

The Nash equilibrium