Is There a Macroeconomic Trilemma? A Theoretical Analysis

Abstract

The article examines the view in international macroeconomics that has become known as the ‘Macroeconomic Trilemma’, the ‘Impossible Trilemma’, or simply the ‘Trilemma’. According to this view, national policy makers can reach two out of three desirable states: (i) free capital flows, (ii) exchange rate stability, and (iii) monetary policy autonomy, the latter implying the ability of monetary policy to pursue a production goal. It follows from the Trilemma that national policy makers with a closed capital account, i.e. choosing not to have (i), are both able to reach exchange rate stability and to use monetary policy for the pursuit of a production goal (monetary autonomy), i.e. the two desirable states indicated by (ii) and (iii). The implication is that it will be possible with the use of only one policy instrument, i.e. monetary policy, to reach two policy goals (an exchange rate goal and a production goal). This contradicts the Tinbergen rule, according to which the number of achievable policy goals cannot exceed the number of independent policy instruments. On the basis of a simple macroeconomic framework, the article disproves this part of the Trilemma. Thus, when capital markets are closed, national policy makers can reach only one policy goal – either an exchange rate goal or an employment goal – when they control only one policy instrument, i.e. monetary policy.