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The impossible trinity

IF _ FTU _ Group 3
by

Cuong Thai

on 25 March 2014

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Transcript of The impossible trinity

The impossible trinity
Groups' members
Trieu Thuy Quynh
Ngan Ba Dat
Than Duong Thuy
Luong Dinh Long
La Thi Tuyet Mai
Thai Manh Cuong
Lien Phuong
The impossible trinity definition
The Mundell - Fleming Model:
A economic model first set forth in the early 1960s by Robert Mundell and Marcus Fleming.
Assumption: the price level is fixed and then show what causes short-run fluctuations in aggregate income in an open economy.
The Mundell - Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed.
The impossible trinity definition
The Mundell - Fleming Model:

A economic model first set forth in the early 1960s by Robert Mundell and Marcus Fleming.
Assumption: the price level is fixed and then show what causes short-run fluctuations in aggregate income in an open economy.
The Mundell - Fleming model shows that the effect of almost any economic policy on a small open economy depends on whether the exchange rate is floating or fixed
The impossible trinity definition
The Impossible Trinity (Trilemma)

It is impossible to have all three of the following at the same time:
A fixed exchange rate
Free capital movement (absence of capital controls)
An independent monetary policy
It is a hypothesis based on the uncovered interest rate parity condition
Fixed exchange rate
The Government or Central bank sets a stable numbers of exchange rates for value of the domestic currency compared to the value of foreign.
For example:
Buy goods in Vietnam and sell to EU with floating exchange rates
Buy = 10,000,000 VND
Sell = £400

At to: E = 30,000 VND/GPB
=> Sell = 12,000,000 VND => Gain: 2m VND

At t1: E = 25,000 VND/GPB
=> Sell = 10,000,000 VND => no profit

Independent monetary policy
The AMBITION of every nations (utilize the use of interest rates)
For instance:
The recession or slow down economy:
decrease i
=> improve the economy
The overheating economy or too high inflation:
increase i
=> reduce the inflation and balance the economy
Monetary Policy
Independent monetary policy
Open Market Operations
Discount Loans
Changes in Reserve Requirements
Free capital flow
Freedom to move money to other countries and invest easily.
The Impossible Trinity in USA
USA, like Great Britain or Canada, has chosen policy of liberalization of capital flow and use monetary policy to stabilize the economy and to accept its currency float, the dollar.

allows to decrease the impact of some shock and business cycles from the outside
American people can easily invest their money to foreign market
FED use monetary policy to generate jobs and stabilize price.
The impossible
trinity in China
China policymakers have chossen to control capital flows, allowing for a fixed exchange regime as well as independent monetary policy.
The impossible
trinity in China
Why?

Cheaper RMB allows Chinese exports to sell at lower prices. Thus the PBOC effectively subsidizes exporters on the international stage
Costs?
- Use sterilization tools to remove excess liquidity in markets to prevent INFLATION at home
- Property boom => House price rises significantly, Real estate bubble
- Resistance from USA and other countries
The impossible trinity in Thailand (1997)
What happened?
On 14 May and 15 May 1997, the Thai baht was hit by massive speculative attacks. The Thai government was eventually forced to float the Baht, on 2 July 1997.
The impossible trinity in Thailand (1997)
Why?
- The liberalization of capital control
With rapid growth and high i => Thailand received a large inflow of hot money
Huge amount of foreign loan.
- BOT maintained high interest rates in order to boost domestic savings and counter inflationary pressures
=> attract further capital inflows, take back money
=> force E to decrease =>
speculation
(waiting for a sharp fall of E)
- Bank of Thailand retained a fixed exchange rate. It was reported that about $23 billion was sold forward to defend the THB =>
the foreign reserves kept going down
- In 1996 and 1997: A rapid reversal of money flows + Speculative attack =>
July 1997: Gave up defending THB and adopted a floating exchange rate regime
Position "a"
Fixed exchanged rate and free capital flow
- Free capital flow:
Too much $ => Surplus in $ => VND appreciate => E decrease
- Fixed ER:
VND amount increase => Borrow $ to pump more VND

More VND => Inflation
2 choice to reduces inflation
- Interpendent monetary policy
take VND back
raise interest rate of mobilizing VND
- Money union
avoid the conversion
lower foreign exchange risk

Position "b"
Independent monetary policy & Free capital flow

- Independent monetary policy:
In the USA : (Rate of return) i = 5%
In Viet Nam: i = 2%
*Investors sell VND to keep $ => VND depreciate => E increase
*Gov. sell $ (from foreign reserves) to save VND
The reserve is limited

- Free capital flow:
Investors continue to take back $ => VND depreciate => E increase
Can’t keep fixed E
Position "c"
Independent monetary policy &
Fixed Exchange Rate

- Independent monetary policy:
In the USD : (Rate of return) i = 5%
In Viet Nam: i = 2%
*Investors sell VND to keep $ => VND depreciate => E increase
*Gov. sell $ (from foreign reserves) to save VND

- Fixed exchange rate:
Open market operation
Foreign reserve
...
=> take VND back
=> E decrease
Full transcript