The impossible trinity: Trilemma or Dilemma

Abstract

With increasing globalization, more and more of the world’s economies are dependent on each other. Within such macroeconomic conditions, economists have often stipulated the existence of an economic trilemma that the countries face when managing their domestic economies. They stipulate that within a realm of free capital flows across nations, it is possible for countries to maintain independence in their monetary policy only through maintaining a floating exchange rate, whose corollary stipulates that a floating exchange rate enables the monetary policy to be independent. However, as the quantum of capital flows across borders increases and credit cycles in a country obey the global patterns, the domestic monetary policy is also adjusted according to global factors irrespective of the exchange rate policy. This phenomenon is described by economists as the dilemma theory where even if exchange rates are kept floating, countries cannot maintain independence in monetary policy given the condition of free capital flows. Through this paper we try and establish the validity of the dilemma hypothesis for developing countries like India and Brazil which have large amounts of capital flows in and out of the country. By studying the exchange rates, interest rates and capital flow trends, we have analyzed the relationship between the three variables. Further, we have analyzed the mode of transmission of credit creation in each of these countries in order to understand more about the nature of dilemma in their economies.