Macroeconomics

impossible trinity, is illustrated in Figure 12-12. A nation must choose one side of

this triangle, giving up the institutional feature at the opposite corner.

The first option is to allow free flows of capital and to conduct an indepen-

dent monetary policy, as the United States has done in recent years. In this case,

it is impossible to have a fixed exchange rate. Instead, the exchange rate must

float to equilibrate the market for foreign-currency exchange.

The second option is to allow free flows of capital and to fix the exchange rate,

as Hong Kong has done in recent years. In this case, the nation loses the ability to

run an independent monetary policy. The money supply must adjust to keep the

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Dollarization may also lead to a loss in national pride from seeing American portraits on the cur-

rency. If it wanted, the U.S. government could fix this problem by leaving blank the center space

that now has portraits of George Washington, Abraham Lincoln, and others. Each nation using U.S.

currency could insert the faces of its own local heroes.

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exchange rate at its predetermined level. In a sense, when a nation fixes its curren-

cy to that of another nation, it is adopting that other nation’s monetary policy.

The third option is to restrict the international flow of capital in and out of

the country, as China has done in recent years. In this case, the interest rate is no

longer fixed by world interest rates but is determined by domestic forces, much

as is the case in a completely closed economy. It is then possible to both fix the

exchange rate and conduct an independent monetary policy.

History has shown that nations can, and do, choose different sides of the trin-

ity. Every nation must ask itself the following question: Does it want to live with

exchange-rate volatility (option 1), does it want to give up the use of monetary

policy for purposes of domestic stabilization (option 2), or does it want to restrict

its citizens from participating in world financial markets (option 3)? The impos-

sible trinity says that no nation can avoid making one of these choices.

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The Open Economy Revisited: The Mundell-Fleming Model and the Exchange-Rate Regime

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