Trilemma of International Finance
The relative value of any two curren-
cies—the exchange rate—is determined
through their sale and purchase on the global foreign exchange market. If government policy interferes with this market by changing the relative supply or demand of currencies, the exchange rate is managed.
The trilemma of international finance, is a restriction on government policy that follows immediately from the interaction of exchange rates, monetary policy and international capital flows.
The trilemma states that any country can have only two of the following:
- (1) Unrestricted international capital markets.
- (2) A managed exchange rate.
- (3) An independent monetary policy.
If the government wants a managed exchange rate but does not want to interfere
with international capital flows, it must use
monetary policy to accommodate changes
in the demand for its currency in order to
stabilize the exchange rate.
In the extreme, this would take the form of a currency board arrangement, where the domestic currency is fully backed by a foreign currency (as in the case of Hong Kong).
In such a situation, monetary policy can no longer be used for domestic purposes (it is no longer independent).
If a country wishes to maintain control over monetary policy to reduce domestic unemployment or inflation, for example, it must limit trades of its currency in the international capital market (it no longer has free international capital markets).
A country that chooses to have both unrestricted inter-national capital flows and an independent monetary policy can no longer influence its exchange rate and, therefore, cannot have a managed exchange rate.
Pieters and Vivanco (2016), government
attempts to regulate the globally accessible
bitcoin markets are generally unsuccessful,
and, as shown in Pieters (2016), bitcoin exchange rates tend to reflect the
market, not official exchange rates.
Should the flows allowed by bitcoin become big enough, all countries will have, by default, unrestricted international capital markets.
Thus, with bitcoin, (1) unrestricted
international capital markets is chosen by
default.
Therefore, the only remaining policy choice is between (2) managed exchange rates or (3) independent monetary policy.
If the country chooses (1) and (2), it must use reactive monetary policy to achieve the managed exchange rate.
If the country chooses (1) and (3), it must have a floating exchange rate because it has no remaining tools with which to maintain a managed exchange rate.
Ali et al. (2014), the European Central
Bank (2015) and the Bank for International
Settlements (2015) all concur that cryptocur-
rencies may eventually undermine monetary policy.
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