Impossible trinity

The impossible trinity is the principle that a country cannot simultaneously maintain a fixed exchange rate, free capital movement, and independent monetary policy. Choosing two limits the third.

Interest rate parity: A relationship linking interest rates, exchange rates, and expected currency movements across countries. With mobile capital, different interest rates invite currency flows that strain a fixed exchange rate.
Robert Mundell: A Canadian economist known for foundational work on international monetary economics and optimum currency areas. His analysis of capital mobility and monetary policy helped establish the trilemma's theoretical foundations.
European Monetary System: A European framework of exchange-rate cooperation established in 1979 before monetary union. Its exchange-rate commitments exposed tensions between currency stability and national monetary control.
Floating exchange rate: An exchange-rate system in which currency values are mainly determined by market supply and demand. Floating currencies allow monetary autonomy and capital mobility by giving up a fixed exchange-rate target.
Foreign exchange intervention: Central-bank purchases or sales of currencies intended to influence exchange rates. Defending a peg requires intervention that can undermine control of domestic monetary conditions.
Marcus Fleming: A British economist whose work analyzed monetary and fiscal policy in open economies. His open-economy policy analysis developed alongside Mundell's and contributed to the framework.
European Exchange Rate Mechanism: A system that limited fluctuations among participating European currencies before the euro. The 1992 crisis showed how capital mobility could overwhelm attempts to defend exchange-rate bands.
Currency board: A monetary arrangement that tightly links domestic currency issuance to foreign-currency reserves at a fixed rate. It illustrates the sacrifice of monetary discretion used to preserve a peg with open capital markets.
Capital controls: Government measures that restrict cross-border financial transactions. They limit capital mobility, allowing a country more room to set interest rates while pegging its currency.
Mundell–Fleming model: A short-run model of monetary and fiscal policy in an open economy with capital flows. The model makes the conflicting effects of exchange-rate commitments and monetary policy visible.

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