, "The Trilemma Problem"
is one concerned with the incompatibility of currency mechanisms, capital controls
and demand-side management
An economy can only have two of the following.
- Fixed Exchange Rates
- Free Capital Mobility
- Independent Monetary Policy
In systems where 1 and 2 exist, such as under the Gold Standard
, a country must use its monetary policy
to remain on the system, otherwise destabilising capital flows
), will cause its fixed exchange rate to collapse.
In systems where 1 and 3 exist, such as in the Bretton Woods system, capital controls are used to allow countries to run their own independent monetary policy, keeping unemployment low, whilst at the same time having fixed exchange rates.
Most major economies in the world today have floating exchange rates, conditions 2 and 3. This allows for free movement of capital, which is good for growth, and independent monetary policies which can keep unemployment low. Unfortunately, it also means wild fluctuations in exchange rates which periodically wreak havoc in the manufacturing sectors of economies as a means of controlling inflation.