Answer to Question #102007 in Macroeconomics for Jorge Ferreira

Question

What are some of the main advantages and disadvantages of fixed vs floating nominal exchange rates? Briefly describe the idea behind the Mundel's Trillema and discuss the constraints it effectively imposes on domestic monetary policy. How countries have dealt with trillema problem?

Answer 1

Advantages of floating exchange rate include; a deficit in the balance of payments would trigger currency depreciation. This would make a country's exports cheaper in foreign markets, increasing their demand and ultimately restoring equilibrium in the balance of payments. Advantages of fixed exchange rates include; avoid currency fluctuations, stability encourages investment, Keeps inflation low and current account.

The disadvantages of a fixed exchange rate include, preventing adjustments for currencies that become under- or over-valued, limiting the extent to which central banks can adjust interest rates for economic growth, requiring a large pool of reserves to support the currency if it comes under pressure. Floating exchange rates have the following advantages; automatic stabilisation, freeing Internal Policy and absence of crisis.

The impossible trinity (also known as the trilemma) is a concept in international economics which states that it is impossible to have all three of the following at the same time: a fixed foreign exchange rate. free capital movement (absence of capital controls) an independent monetary policy.When making fundamental decisions about managing international monetary policy, a trilemma suggests that countries have three possible options from which to choose. According to the Mundell-Fleming trilemma model, these options include:

• Setting a fixed currency exchange rate
• Allowing capital to flow freely with no fixed currency exchange rate agreement
• Autonomous monetary policy