Lesson 4
The Impossible Trinity
When analyzing any country's macro setup, identify which two of the three they've chosen. This tells you their vulnerabilities. Countries with dollar pegs and free capital flows are exposed to Fed policy.
Why can't countries just fix their exchange rates AND have independent monetary policy AND allow free capital flows? Because of the 'Impossible Trinity' (or Trilemma).
The Three Goals:
- Free Capital Flows: Money can move in and out of the country freely
- Fixed Exchange Rate: Currency pegged to dollar or other anchor
- Independent Monetary Policy: Central bank can set rates for domestic needs
You Can Only Have Two:
If you try for all three, markets will break you.
The US Chooses: Free capital flows + Independent monetary policy + Floating exchange rate. The dollar floats, allowing the Fed to set policy for domestic goals.
China Chooses: Managed exchange rate + Independent monetary policy + Capital controls. China restricts capital flows, allowing them to both manage the yuan AND set rates independently.
Eurozone: Free capital flows + Fixed exchange rates (euro) + No independent monetary policy. Individual countries can't set their own rates.
Why This Matters:
The trilemma explains why certain countries are constrained:
- EM countries with dollar pegs are vulnerable to Fed policy
- China can ease while the Fed tightens because capital controls protect them
- Eurozone members can't devalue to solve local problems
Check your understanding
Lesson Quiz
Quiz Check
What is the 'Impossible Trinity' and why does it matter for macro analysis?