The Impossible Trinity - The Exchange Rate dilemma.

hi everyone so there is an impossible Trinity which exists when it comes to international economics and that really relates to a country's choice of the exchange rate a country cannot have a perfect rating okay there is no perfect rating that actually exists so therefore countries must make a choice as to what is most suitable for them in their given economic circumstances now countries that are able to actually get two out of three of this impossible Trinity so it's impossible to have all three of the following free capital flows a fixed exchange rate and independent monetary policy you just cannot manage all three areas that are okay so let's take a look at the reasons for this firstly if we consider free capital flows if you have free capital flows it means there is an absence of capital controls there are no restrictions in terms of actually converting money into a foreign currency and you make your currency readily available for such transactions and it also means that you've got a fully liberalized capital account and that means you can attract but long-term inward foreign direct investment into your country but you can also attract a lot of shorter term speculative investment into your country as well okay now that's what some speculative investment may go into the stock market it could go into bond markets within your local country there okay so in essence money is readily convertible and suddenly you can enjoy big big sways of money coming into your country but you can also notice big withdrawals coming out of your country and this can pose big problems for countries that are developing and have very little experience of actually dealing with such large volumes of money okay very immature financial sectors really okay so we've got free capital flows there and we've got a fixed exchange rate okay so this is quite similar to the which actually runs in Hong Kong Hong Kong enjoys free capital flows has got a very open capital account and it's also got a fixed exchange rate with regard to the US dollar and it's actually I believe the longest-standing pegged rate against the US dollar in existence now to actually manage this scenario Hong Kong have have developed a huge huge quantity of foreign exchange reserves they actually have one dollar for every $1 worth of Hong Kong currency in circulation at any given time so it means their domestic currency is fully backed by their international word reserves and that enables confidence be maintained that they can always buy back their currency and hold its value okay so Hong Kong provides us with a nice suitable example that some other countries have tried this previously led seas have tried this and they've really had a lot of problems when it's come to the free capital flows that have flowed into the country and caused a lot of damage to the financial sector as suddenly that money has been withdrawn and we'll look at that and lesson on the Asian financial crisis okay so then if we shift to China in the regime that actually runs in China what timing it doesn't allow that those free capital flows to actually come into their country with ease and there are restrictions in place to actually stop hot money flows coming into China so there are capital controls here but it does give them independence of monetary policy Hong Kong meanwhile of generally generally not so much in the last year which concerned a few people actually but generally Hong Kong's interest rates of course have remained on a parity level with the US Federal Reserve okay so that it means that whenever the US has changed its rate interest rates the Hong Kong monetary of Authority has also done something very very similar okay they've chosen not to do that in recent times and that's meant that there they are now at the bottom band of their actual exchange rate regime okay so some people are actually questioning now where the Hong Kong can maintain it when they're trying to actually have some independence over their monetary policy but nevertheless because China do not allow money to easily flow in and flow out of their country then it means that yeah they can maintain some independence over that well a great deal of independence over that monetary policy and maintain that fixed rate okay so most M EDC's tend to opt for this sort of scenario though so where they have the benefits of an independent monetary policy and they have free capital flows but of course when it comes to word that independence and monetary policy when you change interest rates that has an impact on the the fixed exchange rate because of the freedom of capital flows that actually exists so just recently was expected that the UK was going to increase interest rates in May 2018 as we are now but yeah our economic growth data has come out very very weak for the first quarter of the year just point one percent and as a direct consequence of that the Bank of England said look you know we will not be increasing interest rates and all the market got that picture anyway and as a direct consequence that it meant that our exchange rate depreciated slightly it came down from about one point four down to about one point three seven per dollar okay so that independence and monetary policy and the freedom of capital flows to actually God take money wherever they want to place it of course you are going to seek out the best monetary policy returns the best interest rate returns that you can with that money if you're saving it in foreign currencies okay so really this does highlight the choices the countries need to make and this is really really significant when it comes to LED see so opt for this sort of area we know there are potential vulnerabilities with LED sees and developing economies who are likely to have a lack of experience in really being able to cope with a big big inflows of hot money capital okay so there could be some restrictions that are placed upon that which almost sort of moves it towards a sort of Chinese system anyway you know the main takeaways here there is no perfect regime and therefore the choice depends upon priorities and circumstances but if you get an essay on exchange rates and it's asking you you know about the optimal regime or anything like that this is a wonderful concept to actually evaluate that there is no perfect regime of course okay and all countries must make a choice okay thanks ever so much guys hope that was helpful

Channel: Enterprise, Economics & Business

Views: 47,539

Keywords: exchange rate, impossible trinity, monetary policy, pre u economics, a level, economics, cambridge, international, macro, exchange rate dilemma, exchange rate trilemma

Id: HLfceACjPNY

Length: 7min 39sec (459 seconds)

Published: Tue May 08 2018