Open-economy policy
In an open economy, exchange rate regimes and capital flows shape what monetary and fiscal policy can achieve.
The impossible trinity
The 'impossible trinity' or trilemma says a country cannot have all three at once: a fixed exchange rate, free movement of capital, and an independent monetary policy. It must choose two. The euro area countries chose fixed rates (a shared currency) and free capital, giving up independent national monetary policy.
Fixed exchange rates
To maintain a peg, a central bank must buy its currency when it is under pressure to fall and sell it when it is pressured to rise, using foreign exchange reserves. If reserves run out or the peg looks unsustainable, speculators may attack it, as in the 1992 crisis that forced the UK out of the European Exchange Rate Mechanism.
Currency crises
Currency crises occur when investors rapidly pull money out of a country, causing a sharp depreciation. The 1997 Asian financial crisis began in Thailand when its currency peg collapsed, spreading to Indonesia, South Korea, and others. Countries with large foreign-currency debts suffer most, as depreciation increases the local-currency value of what they owe.
Monetary policy in an open economy
With a floating exchange rate and free capital, monetary policy is powerful: lower interest rates both boost domestic spending and weaken the currency, raising net exports. Under a fixed exchange rate with free capital, the central bank must match the anchor country's interest rates, so it loses this tool.
Fiscal policy in an open economy
With a floating rate and mobile capital, expansionary fiscal policy may push up interest rates, attract foreign capital, and strengthen the currency, reducing net exports and partly offsetting the stimulus. Under fixed rates, fiscal policy tends to be more effective, because the central bank keeps rates steady.
The euro
The euro, launched in 1999 for electronic transactions and 2002 for notes and coins, is used by 21 EU countries (Bulgaria joined in 2026). It eliminated exchange rate costs and risks within the area, but members cannot set their own interest rates or devalue in a crisis, which made adjustment painful for countries like Greece and Spain after 2010.
Reserve currencies
The US dollar is the world's main reserve currency, held by central banks and used for much of global trade and finance. This brings the US benefits, such as cheaper borrowing, and means US monetary policy affects the whole world: when the Fed raises rates, capital often flows out of emerging markets.
Worked example
A small country pegs to the dollar and allows free capital flows. When the Fed raises interest rates, investors would move money to the US unless the country raises its rates too. To keep the peg, it must raise rates even if its own economy is weak: the trilemma at work.
Key takeaways
The trilemma says a country can choose only two of fixed exchange rates, free capital, and independent monetary policy. Pegs require reserves and can face speculative attacks. Currency crises, like 1997 in Asia, hit hardest where debt is in foreign currency. Monetary policy is strong under floating rates; fiscal policy is stronger under fixed rates. The euro removed exchange rate risk but limited national policy. US policy affects the world through the dollar's role.
Flashcard
Fixed rate, free capital, independent monetary policy: pick two
Check your understanding
According to the impossible trinity, a country with a fixed exchange rate and free capital movement must give up: