Essay: Mundell-Flemming Trilemma – Tradeoffs

Tradeoffs cannot be classified as either right or wrong as they are very circumstantial. States often determine tradeoffs between international and domestic objectives by taking and adapting past policy to current economic circumstances and determining what objectives are valued most. A change in economic conditions most often brings a change in monetary policy from the most previous policies, as a tradeoff that might be right at the time can grow to be temporarily obsolete, depending on where the state is suffering and where the world is striving. These tradeoffs are often summarized with the Mundell-Flemming Trilemma, which creates a tradeoff between capital mobility and stable exchange rates, both international objectives, and monetary policy independence, a domestic objective. The Trilemma, also referred to as the impossible trinity, states that, although all three objectives are desired, it is only possible to achieve two.
There are four different periods of economic history that outline the major effects of every possible tradeoff created by the impossible trinity. As the gold standard spread across the world and was adopted by more and more countries, a fixed exchange rate became ubiquitous across member countries along with capital mobility. Foreign investment and trade were boundless until the domestic tradeoff of member states caught up with them. With the gold standard came new monetary policy that was solely determined to protect the integrity of the gold standard internationally. By giving up the right to individual monetary policy, especially fluctuating exchange rates, states could no longer protect themselves from any sort of economic turbulence. With the gold standard eventually came deflation which, when paired with no individual monetary policy, causes recession. As the monetary bases continued to dwindle with no way of enacting policy to maintain it, a great depression came about. For years, countries raised interest rates to hopefully solve a problem caused by the effects of the gold standard: good and commodity deflation, no ability to devalue currency, and forced capital openness for gold to move across state borders. Finally, with the US taking the lead, the gold standard was abandoned.
Between World War I and World War II, the world saw an unstable international economy as every nation changed focused from the solely international objectives of the gold standard to more domestic objectives to mend all the damage caused my economic disaster. This period was flagged with nations focused on their individual monetary policy, focusing on fluctuating exchange rates to allow for much needed devaluation form the past era along with capital controls and trade barriers to stabilize the domestic banks and flow of currency. Going from one extreme of total international policy to fixing the damage with solely domestic policy created more issues and the world needed a monetary policy the balanced both international and domestic objectives, which soon became known as the Bretton Woods Agreement. The International Monetary Fund and World Bank were created along with a return to fixed exchange rates tied to gold prices, which had become volatile throughout the depression. What differed this time was that agreeing nations had control over their individual monetary policy. According to the trilemma, this meant free-capital movement would not be possible and capital control could be used as monetary policy, along with other methods, to protect domestic economies.
The Bretton Woods Agreement only lasted for so long as President Nixon saw it was time for the US Dollar to abandon gold as other major nations began to profit off of the weakening dollar (Root). With countries using capital control for solely domestic gains, the international economy started to break down. It was realized that free capital movement coupled with individual monetary policy trumped a fixed exchange rate, which had been taken advantage of. This post-Bretton Woods Agreement monetary policy has been adopted by the US as it is what fits its economic conditions and interests best. Americans have the right to flourish in the international economy while the Federal Reserve ‘sets monetary policy to try to maintain full employment and price stability’ all at a cost of having a volatile exchange rate (Mankiw).
Recall that economic tradeoffs are circumstantial and the policies of the US may no be favorable to another country. China values its central control over policy and exchange rates but at a cost to having capital controls, similar to the Bretton Woods Agreement. The European Union has ‘eliminated all exchange-rate movements within their zone’ yet wealth can move freely (Mankiw). Like the Mundell-Fleming Trilemma states, the tradeoff is giving up the ability to create national monetary policy, similar to that of the gold standard era. The best monetary policy and economic tradeoff is contingent upon what objectives are most valued, therefore, yes, states do learn from past monetary order but these lessons are used to suit each nations best interests, not to define a definite right and wrong.