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The Impossible Trinity Reveals Economics Essay

Introduction The Impossible Trinity reveals that a country cannot have: 1) Fixed Exchange Rate, 2) Free Capital Movement and 3) Independent Monetary Policy all at the same time. It can only choose two out of the three factors.
The fixed exchange rate regime enables a home currency to be pegged to a single currency; to a basket of currencies or to an economic unit of gold. A pegged currency usually adheres to the same interest rate of the reserve country.
The fixed exchange rate is implemented to stabilize home currency’s value against the currency it is tied to; preventing extreme fluctuations. Also, a fixed exchange rate helps fosters a desired conductive environment that facilitates trade.
Free Capital Movement creates the freedom for investments to move in and out of the country; where trade barriers such as embargoes, quotas and tariffs are eliminated. This attracts foreign investments where developing countries can benefit from foreign expertise and know-how. It also enables countries to source of external funds should a crisis occurs.
Independent monetary policy refers to monetary authority’s autonomy to regulate money supply in the market. As a result, the central bank can exert authority to adjust interest rates to reduce unemployment or to curtail inflation. Also, this entitles them to make decisions strictly based on economic goals without being influenced by political interests or pressures.
Three Possible Combinations As suggested by Paul Krugman, a country can only choose 2 out of the three factors. The following are the three possible combinations within the trinity.
Fixed Exchange Rate and Free Capital Movement Independent monetary policy is forgone in this situation. Since capital is allowed to flow freely; the buying and selling of the currency is completely controlled by the market’s demand and supply. If Foreign Direct Investments (FDI) increases; hot money will enters into the home country with ease, increasing the demand for domestic currency. The increase demand would cause the domestic currency to appreciate. However, the fixed exchange rate in this scenario does not allow the currency to increase in value. Rather than appreciating, the central bank has to sell more home currency in the foreign reserves market to maintain its pegged currency. This causes the amount of its domestic currency in reserves to decrease. Also, the central bank will not be able to adjust interest rate as that would again impact the fixed exchange rate economic goal. Thus, the independent monetary policy cannot be supported under the fixed exchange rate and free capital movement combination.
Free Capital Movement and Independent Monetary Policy Fixed exchange is forgone in this scenario. With an independent monetary policy and free capital movement; any changes in interest rates by the central bank would drastically affect the circulation of capital. Take for example the central bank lowers the interest rate. Due to free capital movement, hot money will move out and into to another country that offers the higher interest rate. The selling of home currency to buy the foreign currency with the higher interest rate would result in a decrease in demand for the home currency in the exchange market. This causes the value of the home currency to depreciate against other currencies. Therefore, a fixed exchange rate cannot persist. The same concept applies when the central bank decides to raise interest rates.
Fixed Exchange Rate and Independent Monetary Policy China at present adopts this combination. With a fixed exchange rate and independent monetary policy, a country’s central bank has to control capital movement. Take for example a booming economy. With strong capital inflows, this would lead to a greater demand for the home currency. However, this also increases the country’s risk of inflation. To curb the inflation, the central bank would then raise domestic interest rates relative to the base country due to the fixed exchange rate criteria, which on the contrary, will result in even more capital flowing, causing a higher risk of inflation. Thus, the country has no option but to give up free capital movement to manage money supply in order to curb inflation.
In reality, this combination in the impossible trinity is ineffective in an open economy. The central bank although free to make monetary decisions free from the government’s authority; has very little control over its exchange rate and interest rate, making this combination very unsustainable. Countries thus cannot afford to implement this combination if they are not ready to give up free capital movement, by allow currency to appreciate or depreciate as dictated by base country; or to forgo independent monetary regime through allowing domestic interest rates to be determined by interest rate of the base country.
3. China’s Economic Outlook Today, China is the most populous country in the world with a total population of approximately 1.344 Billion. Also, it is the second largest economy in the world, registering an average GDP growth of 10% per annum. US is still China’s largest trading partner; followed by ASEAN, Europe and Australia.
With relatively weak imports coupled with the nation’s high saving rate in which Chinese residents only consume 36% [1] of the country’s GDP; China managed to secure USD$31.7 Billion in trade surplus this year, while accumulating a staggering USD$3.28 Trillion in foreign reserves through the years.
Thus far, China is largely export-driven, comprising of 39.7% of its annual GDP; where the country mainly exports electrical machinery, textiles and manufactured goods; registering USD$186 Billion [2] in export revenues, as of September, 2012.
China’s Trinity Based on the above analysis, China’s trinity consists of independent monetary policy and fixed exchange rate, forgoing free capital movement. However, there are several key issues pertaining to this combination such as the effectiveness of China’s capital controls; and how this will affect its ability of China to maintain a fixed exchange rate and retain monetary independence.
Looking at China’s fixed exchange rate regime, its currency was pegged 8.27 RMB to 1 USD between 1994 and 2005. With overheating concerns and extreme liquidity (from competitive pricing as a result of an under-valued RMB); China eventually gave into pressures from the International Monetary Fund (IMF) and trade barrier fears to remove the pegged exchange rate in 2005. From 2005 to 2008, the Chinese RMB started to appreciate gradually. However, in 2008, it converted back to the fixed exchange rate due to the financial crisis. Shortly after in 2010, China reformed its peg to the crawling peg, where it fixes its exchange rate but changes the fixed rate periodically. The relative stable exchange rate provides China with more certainty through lessen speculative activities and a conducive environment that facilitates trade.
In terms of independent monetary policy, China has a central bank, also well known as the People’s Bank of China (PBOC); which is independent from the government and who holds authority to control interest rates to achieve macroeconomic stability for the country. Currently, the PBOC sets a higher interest rate that serves as a corrective mechanism to correct for the rising inflation rate.
As part of China’s efforts to control capital flow, its government strictly regulates the inflow of hot money from FDI into the country; so as to control money supply and to prevent easy credit. For instance, foreigners cannot purchase a property without studying or working in its country for at least a year. Besides maintaining the inflow of hot money, outflow of currency is also stringently regulated. For instance, Chinese citizens going abroad can only carry a certain amount of domestic and foreign currency out of the country to maintain money supply equilibrium. However, is capital control the way forward for China?
It can also be seen that although China pursued capital control, it still has some form of capital movement through the central bank regulating its inflow/outflow of capital. With China’s huge trade surplus and currency appreciation, it certainly cannot afford to restrict its capital movements as that would cause high inflation rates and erode its economic competitiveness. Thus far, China is employing sterilization policies or the buying and selling of foreign reserve currencies, to directly controlling the supply and demand of the currency in the economy. For instance, the buying of foreign assets which initially go to other countries will then soon circulate back into the Chinese’s economy as payments for exports. Temporarily “parking” its cash into another country helps to reduce money supply in its own economy to fight inflation.
However, its sterilization operations have in recent years proven to increasingly costly. China’s state-owned banks have also relaxed its lending requirements due to huge credits in the market. This thus led to high risk lending and borrowing.
As a result of high borrowings, there have been an increase in non-performing loans (NPL) or loans which have exceeded 90 days or more in payments of interest rate. In 2003, NPL alone conceding 47% of China’s GDP. This forced the central bank to set a limit to the reserve ratio on China’s state-owned banks to prevent China’s banking system to collapse.
China has since resolved this issue by gravitating towards freer capital flow. This allows foreign banks to enter into China’s banking system, inducing competition to its state-own banks. These new bank entrants thus create a competitive playing field which inevitably compels state-own banks to operate and allocate resources more efficiently in order to remain competitive. As a result, NPL has decreased over the years, with state-owned banks gaining competitiveness and profitability.
Overall, the paper concluded that capital controls is least likely to be sustainable for China in the long term. If China continues to tighten capital controls, it will lose its national economic competitiveness due to missing developmental opportunities; which is crucial for China’s economic progress. It is also important to note that the world economy today is increasingly interdependent and the way forward for China could inevitably be financial integration though freer capital flows; to ensure its country’s long-term economic growth.
As the paper revealed, China is moving towards freer capital flows. Thus far, China’s economic developments are challenging the prevailing nature of the impossible trinity. Looking at future developments, more studies needs to be conducted to identify better ways to mitigate the Trilemma in the long run.

A Myth Of The East Asian Miracle Economics Essay

The extraordinary economic growth and development of East Asian over the last four decades has been remarkable to world. Such as the East Asian Miracle suggested that (World Bank, 1993), it is a “Miracle”. The miracle means rapid social development and economy growth, reduced inequality, rapid output in agriculture, the transformation from high to low mortality and expansion on primary and secondary education. Exactly, East Asian economies have the highest growth rates in the world for the past half century. Eight countries are the main contributors to the phenomenon: Japan, Hong Kong, the Republic of Korea, Singapore, Taiwan (China), Thailand, Indonesia and Malaysia, which set the High Performing Asian Economies (HPAEs)¼ˆWorld Bank, 1993¼‰are the subject in this paper.
It is interesting that to find out the different accounts of the East Asian miracle. Firstly, World Bank (1993) argued that the HPAEs to achieved their dramatic growth rates by “getting the basic right”, which were operating sound economic policies, expanding the quantity and raising the quality of physical and human capital. Secondly, according to Stiglitz and Yusuf (2001), need follow the fundamentals of macroeconomic management, which including a stable business environment with relatively low inflation, sustainable fiscal policies, financial development to maximize domestic savings and promote efficient allocation, minimize price distortions and spread of primary and secondary schooling. Thirdly, Davis (2000) argued the factors that could explained HPAEs were initial conditions, policy variables, demography, resources and geography. From above theories, it is clearly found that the main keys to achieve East Asian Miracle were economic and government policy, macroeconomic management and improve the level of education or in other words, the role of education.
The economic and government policy is the most important factor to explain East Asian’s superior economic performance. It is including trade policy, saving and investment policy, industry policy, fiscal policy and Foreign Policy. For example, it is well known that economic and government policy has played a key role in the success development of Taiwan’s economy. Kuo (1999) pointed that China government use case-by-case innovations instituted in response to face economic problems in Taiwan, and always step by the principle of “growth with stability”. Data could always explain the real situation. According to Kuo (1999), from 1952 to 1994, the real GDP of Taiwan (China) grew at an average rate of 8.6 percent per annum and the real per capita GNP grew at 6.3 percent. Further more, the annual inflation rate was 4.3 percent on average and since 1965, the unemployment rate has been below 3 percent. For national saving and investment policy, to a certain extent, it is undoubtedly the high domestic savings means high growth economies. McNicoll (2006) pointed that Singapore and Malaysia are applying mandatory provident funds to ensure the country’s fiscal revenue. While there were many similarities in the policies adopted in these East Asian countries, they used different combinations of economic and government policies to keep their economic growth. Table 1 show the economic growth and demographic transition in selected East Asian countries in the past four decades.
The HPAEs recognized that macroeconomic management was also played an important role in their countries’ economic development. Here, macroeconomic management including low inflation, social stable, high national savings, encouraged private investment and hold a stable financial environment to attract foreign investment. As the East Asian become more closely to the global economy, or in other words, to be an important part of global economy, a good business environment is essential condition. According to the East Asian Miracle (World Bank, 1993), the book used”Pragmatic Orthodoxy” to explain macroeconomic management. It pointed four methods to macro-control: balanced budget deficits, maintain low inflation, control external debt and keep the exchange rate in line. Further more, it used Republic of Korea as an example in responding quickly to macroeconomic crisis. In 1979, Republic of Korea faced variety of problems, such as rising oil price, high interests rates cause high cost of debt service, decline output and incomes so national savings had dropped. However, Korea responded those problems quickly. The government ended the fixed exchange rate and tightened monetary and fiscal policy, in order to keep high investment, the government continued foreign borrowing throughout the crisis. As a result, the inflation and current account deficits were decreasing from 1982 to 1983. Overall, South Korea used the effective macro-control, through this economic crisis.
It is widely know that education is the key element in rapid social development. The strong relationship between well trained and educated labor force and rapid economic growth is so clearly. Todaro and Smith (2009) argued that education is the basic “objective of development”, especially for developing countries. Education gives them abilities to develop modern technology, which is the fundament of a sustainable development economy. Table 2 show enrollment rates of Thailand in secondary education in 1989 and 1994.
With the spectacular economic growth in Thailand, employment rate also increased significantly. Although the income disparities became larger than before, the education level is the key factor to explain these disparities. As primary and lower secondary education became widespread, the higher education has been expanding but still limited for public. However, it is still note that with the improvement of education, the economy is growing rapidly.
Although The East Asian Miracle was real happened, there has been much debate about the East Asian economic development and growth. However, HPAEs show that remarkable growth is possible, it really improve the social development and reduced the poverty in their countries, but behind those dramatic increasing figures, the crisis and some significant problems still exist. The most significant problem is the rising of inequality. Table 3 shows the inequality in East Asian.
The risen inequality were so clearly in China, Hong Kong (China) and Thailand. The one reason for Thailand is the gap in education. As an increasing in high income for higher level of education, cause well-trained and skilled labor forces distinguish from those primary and secondary educated labor forces. Another example is the income gap between rural and urban areas in China. According to Ahuja, Bidani, Ferreira and Walton (1997), the most important reason was the “inter-provincial gap”.
Except the rising of inequality, Stiglitz (2001) suggest that all these countries in East Asian region would “re-examine their risk management strategies”. As those nations have their policies for their respective national conditions, such as education in Thailand, the population and income gap in China. While keeping a clear mind and continue those remarkable economic growth is difficult, especially East Asian economy become one of the most important regions of the global economy. How to reduce their exposures with expanding international market will become a serious challenge for East Asian countries.
The HPAEs was exactly proved the economic development miracle. These East Asian countries developing their national economies and reduce poverty by using effective policies, macroeconomic management and improve the level and education. While at the same time, economy challenge still remaining, such as minimize inequality, balanced social development and environment and find their new positions in global economy.