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THE IMPOSSIBLE TRINITY: ROBERT MUNDELLS

PATH BREAKING CONTRIBUTION IN THE FIELD OF
ECONOMICS












BY

RADHIKA PANDEY

NATIONAL LAW UNIVERSITY JODHPUR [INDIA]
rpandey@nlujodhpur.ac.in
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THE IMPOSSIBLE TRINITY: ROBERT MUNDELLS PATH
BREAKING CONTRIBUTION IN THE FIELD OF ECONOMICS

BY
RADHI KA PANDEY
1


Nobel Laureate Robert A Mundell has made signif icant
contributions in t he f ield of int ernati onal macroeconomi cs
parti cul arl y i n t he area of monetary and f iscal dynami cs. He
point ed out that in countries where monetary and f iscal
poli cies are used to attai n internal bal ance in t he f orm of
demand- suppl y equi librium and ext ernal balance in t he f orm
of balance of payments equi libri um, monet ary policy should
be reserved f or att ai ning t he desired l evel of ext ernal balance
and f iscal poli cy f or preserving int ernal balance. This
concl usion di rectl y f ollows f rom what is t ermed as the
Impossible Tri nit y according to whi ch there is an intrinsi c
incompatibi lit y between a) perf ect capit al mobilit y, b) f ixed
exchange rat es, and c) domesti c monetary autonomy. The
present paper is an attempt to explai n the nuances of t he pat h
breaki ng concept of Impossible Trini ty.

Key words: Impossible Trini ty, Interventi on, Monetary
Poli cy, Fi scal Poli cy, Sterili zation.


INTRODUCTI ON
The concept of Impossibl e Trinit y invol ves an underst andi ng of several
underl yi ng macroeconomi c fundament als and t heir ill ust rations through

1
Lecturer, Department of Policy Science, National Law University, Jodhpur. Contact:
rpandey@nlujodhpur.ac.in
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the IS-LM curve anal ysis. In t he first part of the paper, an attempt is
made t o anal yze t hese underl ying fundament al concepts.

INTERNAL AND EXTERNAL BALANCE
Every economy t ri es to att ai n macroeconomic equilibrium in the form of
internal and external balance through t he vari ous poli cy i nstruments;
prominent among them being, int erest rates, t axes, level of Government
expenditure and publi c debt. Int ernal Bal ance i s achi eved when
aggregat e demand for domesti c out put is equal t o aggregat e suppl y of
domesti c out put at full empl oyment . If this condi tion i s not ful fill ed,
there will be i nfl ati onary pressures or recessionary pot enti al according
to whether aggregat e demand respectivel y exceeds or falls short of ful l
empl oyment output
2
. The components of Aggregat e demand can be
expressed in terms of the following equat ion:
Y
d
= C + I + G + NX
Where C is consumption expendit ure, I i s Investment expenditure, G is
Government expendi ture and NX is net exports. We can break NX in
terms of its t wo components export s and imports as:
NX = X
0
mY
where X
0
are exports and mY are imports. This form implies that a
parti cul ar economy' s exports are exogenous (X
0
) but its import s are a
functi on of its own nati onal income, Y. Here m is the margi nal
propensit y to import out of income and we assume that 0 < m < 1. We
obt ain goods market equilibrium when aggregat e suppl y meets aggregat e
demand, Y = Y
d
where Y
d
is aggregat e demand and Y is aggregat e
suppl y. The term NX takes int o account onl y t he current account of the
Bal ance of Payments. The Balance of Payments of an economy consists
of current and capi t al account . Whether the Balance of Payment s of a

2
See Generally, Robert Mundell, International Economics, Macmillan: New York, 1968
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country is in surpl us or defi cit depends on the position of bot h the
component account s of the Bal ance of Payments. The Bal ance of
Payment s can be expressed i n t erms of the foll owi ng equation:
BP = NX + KA
where NX is the current account (i. e. net exports) and KA is the capit al
account (domesti c assets owned by forei gners minus forei gn assets
owned by domesti c citizens). The capital account of a country will be in
surplus if t he domestic asset s owned by forei gners exceed the forei gn
assets earned by domesti c resi dents. If BP > 0 t hen we have a balance of
payments surplus; conversel y, if BP < 0 we have a bal ance of payments
defi cit. Bal ance of payment s equi librium is achieved when BP = 0.
Assuming full capi tal account mobi lit y, t he capi tal account is a function
of t he di fference between domesti c int erest rates and forei gn interest
rat es, speci fi call y:
KA = k(r - r*)
if domesti c int erest rat es rise rel ative to forei gn int erest rates, then the
domesti c capi tal account increases as the great er relative att racti veness
of domesti c assets i mplies that domesti c and forei gn ci tizens will buy up
domesti c assets and drop forei gn asset s. In other words i f domestic
interest rat e is great er t han forei gn int erest rate, the capital account of
the Bal ance of Payments would be i n surplus and vice-versa.
An import ant contri bution of the Mundell-Fl emming model has been the
introducti on of the external sect or anal ysis in the conventi onal IS-LM
curves t hrough t he addition of another curve t ermed as t he BP curve.
Effectiveness of Monetary and Fiscal Policy in a fixed exchange rate
regi me: An IS-LM BP curve Analysi s
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In thi s secti on an il lustrati on of the rel ative effect iveness of monet ar y
and fiscal policy i n a fixed exchange rat e regime is made through IS-
LM-BP curves.
IS curve represents combinations of income and int erest rat e at which
the Goods market i s in equili bri um. The shift s in the IS curve represent s
fiscal poli cy actions. The LM curve shows combinations of income and
interest rat e at whi ch the money market is in equili brium. The shi fts in
the LM curve si gnify monet ary poli cy acti ons.
To ill ust rate the i mpact of monet ary and fiscal poli cies on t he balance of
payments posi tion of a count ry, the BP curve is int roduced. The BP
curve shows t he various combi nat ions of income and int erest rat e at
whi ch t he Bal ance of Payments of a country is i n equili brium. The BP
curve is upward sloping. The reason for t he upward slopi ng shape of t he
BP curve is the great advance of Mundel l-Fl eming model over the ol der
Keynesi an model. Suppose we begin wi th BP = 0 (equili brium in the
Bal ance of Payments) at some initi al Y and r confi guration. If Y
increases, then NX falls and thus BP < 0 (Bal ance of payments in
defi cit). Thus, i n order for BP to return t o zero, it i s necessary for KA to
rise - thus domesti c interest rates (r) must ri se. Thus, there i s a positive
rel ati onship bet ween Y and r representing t he balance of payments
equilibrium. Under a fixed exchange rate regime, t here is no obvious
reason t hat we wil l necessari l y be at BP = 0. In ot her words, the IS-LM
equati ons will yi el d a part icular income and i nt erest rate combinati on,
that may or may not be where BP = 0. If equilibrium i ncome and i nterest
rat e combi nat ion is t o the right of the BP curve (e. g. at point F as shown
in the fi gure below), then we have a bal ance of payments def icit (BP <
0); i f equili brium income and i nterest rate combi nations (Y*, r*) is to
the l ef t of the BP curve (e. g. at point G), then we have a bal ance of
payments surplus.
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Considering the i mpact of an expansi onary monetary pol icy through a
ri ghtward shift of the LM curve we find that the new equilibrium
positi on is t o t he right of the BP curve, showi ng thus a balance of
payments defici t. As can be seen from the fi gure gi ven below the
ri ghtward shi ft of t he LM curve gi ves the IS-LM curve equilibrium at
point F whi ch i s to t he ri ght of the BP curve. The Balance of Payments
turns into defi cit because an i ncrease in money suppl y (expansionary
monetary poli cy) results i n a decrease in the rat e of i nt erest which
causes a capit al out flow resul ting in capi tal account deficit. On t he other
hand the consequent increase i n income due to i ncrease i n money suppl y
drives the current account t owards defi cit .




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Similarl y consideri ng the impact of fiscal expansion we fi nd that an
expansionary fiscal poli cy will result i n a surpl us i n the Bal ance of
Payment s. As can be seen from the fi gure given above, a ri ghtward shift
in the IS curve results in an IS-LM curve equilibrium at point G. The
point G i s to the l eft of t he BP curve showing thus, a surplus i n the
Bal ance of Payment s.
However the Balance of Payments defici ts or surplus are not sustainabl e
on t hei r own. A Balance of Payments defi cit i mpli es that there is an
excess demand for forei gn currency which must be provi ded by t he
Cent ral Bank to defend t he domesti c currency i n a fixed exchange rat e
regime. However when the Cent ral Bank sel ls forei gn currency, i t
withdraws domesti c currency from ci rcul ation
3
. This has t he impact of
reducing domestic money suppl y in t he economy. The consequent fall i n
the suppl y of domest ic money as the cent ral bank sel ls forei gn exchange
will graduall y shift the LM back to its ori ginal posi tion and thus
equilibrium wil l ret urn t o E.

The concl usion from this anal ysi s is that monet ary poli cy is ineffective
in rai sing out put level under a fixed exchange rat e regi me and full
capit al mobilit y. To increase t he out put level and to maint ai n the
positi on at F in the fi gure above, the Cent ral Bank must conduct what
are known as "st eril ization poli ci es". This means that by open market
operations or some other domestic t ool, the Central Bank i ncreases the
domesti c money suppl y exogenousl y by exactl y t he same amount as it
reduced money suppl y by the forei gn exchange sal es required to
maint ai n the domesti c currencys exchange rat e. Thus, t he Cent ral Bank

3
A process termed as intervention by the Central Bank.
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"sterilizes" the monet ary effects of bal ance of payments disequilibrium
with monet ary poli cy. Thus i f we maintai n the assumpti on of fixed
exchange rate and no sterilization pol icy, then it i s obvious that fiscal
poli cy i s more effect ive than monet ary policy.

Again considering t he impact of fi scal policy expansi on and consequent
cent ral bank i nt ervention t o maint ain exchange rate, the ri ghtward shi ft
of the IS curve wil l cause a bal ance of payments surpl us at point G. A
Bal ance of payment s surpl us impli es an excess demand for domesti c
currency. The Cent ral Bank intervenes through suppl y of domest ic
currency and absorpt ion of forei gn currency. The implicati on of Central
Bank intervent ion i s the increase in domestic money suppl y whi ch is
mani fest in a ri ghtward shi ft of the LM curve. The new equi libri um, at
point H, is the resulting long-run positi on. Thus, output has increased
tremendousl y i n this case because the money suppl y movements i n the
absence of st erilizat ion reinforce the original fiscal expansion. Thus,
under fixed exchange rates, fiscal policy is hi ghl y effective and
monetary pol icy is ineffective.

From the above anal ysis we fi nd that monet ary poli cy is not effective in
rai sing t he domesti c output l evel under a fixed exchange rat e regime.
Under fixed exchange rat es and perfect capit al mobilit y, it i s t he
internati onal capit al flow t hat dict at es the count rys money suppl y.
Monetary poli cy cannot be pursued independentl y to cat er to domesti c
goals of rai sing output level or reducing inflat ion l evel in a fixed
exchange rat e regime.
Thus as poi nt ed out on the basis of Mundellian anal ysis, under perfect
capit al mobilit y and fixed exchange rates,
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Monetary policy is limit ed t o defending the fixed
exchange rat e, and
Fiscal poli cy can be powerful.

India and the Impossible Trini ty

As a consequence of the Impossibl e Tri nit y, count ries with an open
current account face a confl ict bet ween interest rate poli cy and exchange
rat e poli cy. For Indi a, t he dil emma is relativel y recent. As l ong as t he
capit al account was closed, the RBI could conduct its monetary poli cy
and exchange rate policy independentl y of each other. But since 1993,
with the opening up of t he economy, the t wo are no longer independent.
The confli ct bet ween the domesti c monet ary poli cy and the exchange
rat e poli cy is sharpest when a count ry tri es to keep i ts exchange rate
fixed. At a fixed exchange rat e, net i nflows or out flows have t o be
absorbed by the central bank so that they do not change the exchange
rat e. Reserves go up and down in response to capit al flows, and thus
monetary pol icy is det ermi ned by t he ext ernal sector
4
.

However in the current scenari o with gl obal oil pri ce hike t he domestic
monetary poli cy compulsi ons mandat e a ti ghter wat ch on i nfl ation and
interest rat es. The recent spat e of hi ke in interest rat es mai nl y in the
form of increase i n reverse repo rat es as a liquidit y ti ght eni ng measure
refl ects t he RBIs desire of mai nt aining an independent monet ary poli cy.

Taking the exchange rat e; the second component of t he Impossi bl e
Tri nit y, the RBI has traditi onall y tried t o hol d the "real " (i. e. i nflati on-

4
Ila Patnaik, What next on Interest Rates?, Indian Council of Research on International Economic
Relations(ICRIER) Publications, New Delhi
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adj ust ed) value of the rupee const ant agai nst a basket of currenci es. That
undeclared poli cy sti ll hol ds, yet, the RBI does not al ways int ervene.
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Lastl y, t aki ng the t hird component of the impossi bl e tri ni t y: capit al
flows. If the rupee is ruling stronger, i t would result i n strong capit al
flows i nto the Indi an Fi nancial Market.
And gi ven the hi gh interest rates that exist in the Indi an financi al
syst em, even more money woul d come i n and be invest ed i n the debt and
equit y market -- i f t he RBI woul d allow the bi g i nstit utional players t o
do this.
But it won' t, because this woul d affect t he ot her vari ables negativel y, it
woul d send t he exchange rat e even hi gher, and it would cause probl ems
in managing t he money suppl y (whi ch would impact infl ation).
Therefore, the Indi an Cent ral Bank is treading towards t he pat h of ful l
capit al account convert ibilit y i n a phased- cautious manner.

Conclusion
While formul ating domesti c monet ary and exchange rat e poli cy, the
maj or central banks take int o account the confli cts and t rade-offs posed
by the impossibl e t rinit y. The Impossibl e Trini t y evolved as a result of
Mundell s work act s a guidepost for t he Cent ral bankers all over the
world. The evol uti on of the phenomenon of Impossible Tri nit y has
exposed the domesti c and int ernational monetary syst ems to a wide range
of poli cy debat es as: Should monet ary policy be cont roll ed by currency

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T N Ninan, RBI and the dirty trinity, Rediff Business, May 07,2005
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poli cy? Should monet ary policy be ' used up' for reducing currency
vol atilit y? Is Monet ary Poli cy useful for addressi ng i ssues of i nfl ati on
and slower economi c growth? These are j ust some of the chal lenges and
issues faced by the Central Bankers gl oball y. The extent of exchange
rat e stabilit y or monetary poli cy i ndependence however depends on
domesti c economic conditi ons.



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