Does the Fixed Exchange Rate, Independent Monetary Policy and Free Capital Mobility Work together? - Governor Gvenetadze on "Trilemma"
External shocks pose a particular challenge for small open economies like Georgia. This truth showcased itself in the context of the COVID-19 pandemic - the decline in foreign demand, especially in the tourism industry, and the increase in risk perceptions towards developing countries were adversely reflected in the financial inflows. This, in turn, had an impact on the exchange rate and inflation.
The article explains that in the context of the intensified discussion triggered by the impairment and subsequent inflationary pressure, it is worthy to reflect on a popular opinion that it is easier to achieve price stability with the application of the fixed exchange rate by the National Bank or by replacing the national currency with any other currency.
Robert Mundell, a prominent Canadian economist, along with his British counterpart Marcus Fleming, have made a fundamental contribution to conceptualizing an important issue related to this debate. Professor Mundell, who received the Nobel Prize for his research in this area, has just passed away, and the re-examination of his significant work seems relevant today. Together with Marcus Fleming, he introduced the concept is known as the "impossible trinity", which implies that it is impossible to have all of the three together: an independent monetary policy, a fixed exchange rate regime and the free movement of capital mobility. In other words, a fixed exchange rate precludes the possibility of pursuing an independent monetary policy unless the free capital mobility is restricted.
The article offers a detailed discussion of all the advantages and challenges that an independent monetary policy can have in the presence of a floating exchange rate and free movement of capital.
The full version of the article is available on the blog.