Robert Mundell: Three Choices? Not in My Financial Market! ?

With the bad weather blowing in and holidays around the corner, my mind has slipped into thinking about places I’d rather be than Virginia. Italy, Paris, Switzerland…I have visited Europe a couple times. Unfortunately, as my bank account can’t fund a trans-Atlantic flight, I have had to mostly reminisce of the good times there.

One of my less fond memories during those trips was getting to use the different currencies. The process of working out the exchange rates fascinated to me — at the time I did not have a full understanding of what drove the rates. I traveled when both the pound and euro were strong and again when they were at their weakest points (relative to the dollar). Exchange rates are important because they signal the strength or weakness of a country’s currency. Robert Mundell’s research sheds light on the importance of the choices countries make which ultimately determine how their currency is valued.

Robert Mundell was a Canadian economist who won the Nobel Prize in economics in 1999 “for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas”. Basically, the dude lived and breathed the world of currency exchange. He was drawn into this world when Canada decided to float its exchange rate in the 1960s.

Wanting to study the effects of floating exchange rates, he worked with Marcus Fleming and came up with Mundell-Fleming model of exchange rates. The model’s theorem rests on the crux of what became known as the impossibility trinity. The impossibility trinity states that countries have three main ways to handle financial situations, either through free capital movement, fixed exchange rates or independence in setting monetary policy.

Mundell and Fleming believed it was impossible for a country to have free capital flow, fixed exchange rates, and sovereign monetary policy. In this model, it is only possible to have two out of the three corners of the triangle. Capital flow is the movement of money between areas of space. A good example of this is the European Union’s creation of the Euro to facilitate easy mobility of labor and capital between member countries. Fixed exchange rates are when the country controls what the exchange rate for the currency will be. This is a very common practice in China. A sovereign monetary policy is the ability to use policy options that increase or decrease the money supply. This is very common practice in the USA, where the Federal Reserve uses monetary policy to respond to issues. Robert Mundell believed that for a common currency to work, there needed to be free movement of capital and labor to complement it.

A great case where you can see the impossibility trinity come into play is during the Greek financial crisis. Greece was in massive amounts of debt because of its social welfare programs. However, as a member of the EU, they also opted into using the euro as their currency. As a result, Greece had no ability to use any monetary policy since the EU focuses on using a set currency exchange rate and free capital flow. This means that being a member of the EU, Greece had no ability to engage in any kind of monetary policy to try and solve some of the issues they were having. A fairly popular opinion suggested Greece default on their debt, intentionally increase the money supply, and make the necessary cuts to try and get back to solvency. This would hurt the Greek populace in the short term, but it was never an option because, being members of the European Union, they were already locked into set choices of the impossibility trinity.

Another great example where you can see the impossibility trinity at work is in the United States during the Great Recession. The United States had free capital flow and sovereign monetary policy but no fixed exchange rates. The end result was that the U.S. used monetary policy, for better or worse, to try and address the problems brought about by the recession. A tradeoff of using monetary policy is that the United States is unable to control how its exchange rate fluctuates due to potential shifts in the value of the dollar when doing supply-side solutions. This may lead to higher than normal levels of inflation, which can hurt the consumers in need of help during the recovery process.

It is cool looking at these countries’ currency regimes and seeing how Mundell’s contributions to economics affect the way the currency functions as a result of the type of policies the country pursues. His contributions were so significant, the euro and EU were created and there is a school in China with a department in his name. One could only hope to get to such a level of greatness! Mundell can rave in thought about exchange rates. I will go back to thinking of those more pleasant Euro trip memories, like sitting in the Grand Place in Brussels eating a nice meal with an exquisite Belgian beer. Or that time I was in San Malo, walking along the beach looking at the forts Napoleon had built. Nothing is impossible in my world!

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