![]() ![]() ![]() In order to maintain the fixed exchange rate, central bankers would be forced to use the national currency to buy foreign reserves, increasing the money supply and decreasing interest rates, which would further increase national income. ![]() For example, if fiscal authorities decided to use expansionary fiscal policy to increase national income, this would increase interest rates, which would then induce large capital inflows to the country and create a surplus of foreign currency. On the other hand, fiscal authorities see their policy efficacy improve under a fixed exchange rate regime with free movement of capital. But, in order to maintain the country's fixed exchange rate, central bankers would be forced again to manipulate the money supply, moving interest rates in the opposite direction, and thus negating their original action. In other words, any change in interest rates through the manipulation of the money supply made by monetary authorities would be offset by capital movements in response. In this monetary regime type, as Milton Friedman also points out, monetary authorities lose policy autonomy, and thus, the efficacy of monetary policy. It should be noted that in differentiating between the effects of the following two regime-type decisions, one must note whom each decision constrains and empowers.įixed Exchange Rates with Capital Mobility The following generalized hypothetical examples illustrate the policy trade-offs and constraints created by the Unholy Trinity. Specifically, the policy contraints inherent in the Unholy Trinity affect how policy makers employ macroeconomic stabilization policies to manage national income, unemployment, and inflation. īy applying the above assumption of free capital mobility to hypothetical models, one can see how the Unholy Trinity puts constraints on policy makers. Such uncertainty thus makes exchange rate coordination untenable. īenjamin Cohen argues that although international coordination may solve the problem of the Unholy Trinity with coordinated state action in regard to exchange rates, states are induced by ever-changing incentives to cheat or cooperate on such arrangements in order to further their own short-term policy priorities. This servers as the basis for Milton Friedman’s declaration that flexible exchange rates are necessary for free trade, as foreign and domestic investors must be permitted to freely move capital across international borders to satisfy balance of payments and for governments to retain independent monetary policies, especially as an anti-recessionary measure. As a result, most governments simply cannot impose workable capital controls, which all but ensures that the free movement of capital is one of the two policy directions that governments will choose. Furthermore, capital controls discourage foreign economic actors from investing their capital in a country since they may not be able to freely remove their capital in the future. However, as most governments now know, capital controls are hard to enforce as economic actors are easily able to find ways to evade such restrictions. Out of the three policy directions, states would most likely wish to pursue an independent monetary policy and exchange rate stability. The three policy directions are the free movement of capital, an independent monetary policy, and a fixed or pegged exchange rate policy. ![]() The Unholy Trinity is an international economic principle that the policymakers of a country may pursue only two out of three policy directions. ![]()
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