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Impossible Trinity



The title may suggest that I am writing a post on some movie such as the Mission Impossible series or Blade series. However, for a shock effect that's not the case. Impossible Trinity is basically an economics concept. It is a set of policies which cannot be managed by a single central bank. Let’s say for now it is a set of 3 activities A, B & C, and when the banker tries to achieve A, it can manage B, but it cannot achieve/manage C and so on.
So let’s define the Trinity now. In the example above there are 3 activities A, B & C. Here, A stands for A stable currency exchange rate, B stands for Free Capital Movement and C stands for An Sovereign Monetary Policy. The underlying reason for this theory is the uncovered interest rate parity.

Uncovered interest rate parity states that in absence of risk premium, the arbitrage will ensure that the depreciation or appreciation of a currency vis a vis the other will be equal to the nominal interest rate differential between them. Seems too heavy for a layman? So let’s break it down. Risk premium stands for the premium that may exist when investing in country A over country B. Arbitrage refers to risk free profit which a trader may make when trading in securities or currencies (usually not hedged). Nominal interest rate is that rate and interest which a person will earn when investing in a country. The definition basically states that if all the countries are similarly rated from an investment perspective, the exchange rate of respective countries will be based on the interest rate differential existing between the two countries.

However as we all know, that is not the case as there are many factors to be considered for investment in a currency. This leads to countries regulating their currency movement.  But as we all know & have observed from the recent happenings, when the GDP growth rate of a country is high, investors from different countries tend to invest in such a currency. So, this brings us to the dilemma which goes like this: if the growth rate is high, investment will be high & so currency will be volatile. Now, if the government tries to control free flow of money into the economy, it can do so by reducing the growth rate which means changing the monetary policy. OR if the government wants to maintain the growth rate then it can do so by maintaining the monetary policy & this will impact the free flow of money into the economy due to high growth rate. Either ways, a central bank cannot maintain 3 out of 3 at once. However, the Indian central bank- Reserve Bank of India(RBI) has been doing so since its inception by maintaining a balance between the three of these activities.

Cheers to RBI for doing this & Indian economy reaping the benefits of the same.

Hope this article made sense to the people reading & helped understand one concept of economics which economists use frequently.
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