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ECON 2000 Lecture Notes - Lecture 84: Impossible Trinity, Autarky, Money Supply

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School
York University
Department
Economics
Course
ECON 2000
Professor
Irene Henriques

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ECON 2000
Lecture 84
The impossible trinity
- Impossible for nation to have free capital flows, a fixed exchange rate
and independent monetary policy
- Nation must choose one side of triangle
- First option is to allow free flows of capital and to conduct an
independent monetary policy, as Canada has done since 1970 –
impossible to have fixed exchange rate and instead exchange rate
must float to equilibrate the market for foreign currency exchange
- Second option is to allow free flows of capital and to fix the exchange
rate as Hong Kong has done in recent years
- In this case, nation loses ability to run an independent monetary
policy, money supply must adjust to keep exchange rate at its
predetermined level
- When a nation fixes its currency to that of another nation, it is
adopting that other nation’s monetary policy
- Third option is to restrict the intl flow of capital in and out of the
country as China has done in recent years
- In this case, int rate is no longer fixed by world int rate but is
determined by domestic forces (completely closed economy) – in this
case it is possible to fix exchange rate and conduct an independent
monetary policy
- History has shown that nations can and do choose diff sides of
triangle
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Document Summary

Impossible for nation to have free capital flows, a fixed exchange rate and independent monetary policy. Nation must choose one side of triangle. Second option is to allow free flows of capital and to fix the exchange rate as hong kong has done in recent years. In this case, nation loses ability to run an independent monetary policy, money supply must adjust to keep exchange rate at its predetermined level. When a nation fixes its currency to that of another nation, it is adopting that other nation"s monetary policy. Third option is to restrict the intl flow of capital in and out of the country as china has done in recent years. In this case, int rate is no longer fixed by world int rate but is determined by domestic forces (completely closed economy) in this case it is possible to fix exchange rate and conduct an independent monetary policy.

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Related Questions

Currency Trouble in Malawi Closing Case (Question below article)

When the former World Bank economist Bingu wa Mutharika became president of the East African nation of Malawi in 2004, it seemed to be the beginning of a new age for one of the world's poorest countries. In landlocked Malawi, most of the population subsists on less than a dollar a day. Mutharika was their champion. He introduced a subsidy program for fertilizer to help poor farmers and gave them seeds. Agricultural output expanded, and the economy boomed, growing by 7 percent per year between 2005 and 2010. International donors loved him, and aid money started to pour in from the United Kingdom and the United States. By 2011, foreign aid was accounting for more than half of Malawi's annual budget.

In 2009, to no one's surprise, Mutharika was reelected, president. Then things started to fall apart. Mutharika became increasingly dictatorial. He pushed aside the country's central bankers and ministers to take full control of economic policy. He called himself “Economist in Chief. Critics at home were harassed and jailed. Independent newspapers were threatened. When a cable from the British ambassador describing Mutharika as autocratic and intolerant of criticism was leaked, he expelled the British ambassador. Britain responded by freezing aid worth $550 million over four years. When police in mid-2011 killed 20 anti-government protestors, other aid donors withdrew their support, including most significantly the United States. Mutharika told the donors they could go to hell. To compound matters, tobacco sales, which usually accounted for 60 percent of foreign currency revenues, plunged on diminishing international demand and the decreasing quality of the local product, which had been hurt by a persisting drought.

By late 2011, Malawi was experiencing a full-blown foreign currency crisis. The International Monetary Fund urged Mutharika to devalue the kwacha, Malawi's currency, to spur tobacco and tea exports. The kwacha was pegged to the U.S. dollar at 170 kwacha to the dollar. The IMF wanted Malawi to adopt an exchange rate of 280 kwacha to the dollar, which was closer to the black market exchange rate. Mutharika refused, arguing that this would cause price inflation and hurt Malawi's poor. He also refused to meet with an IMF delegation, saying that the delegates were “too junior. The IMF put a $79 million loan program it had with Malawi on hold, further exacerbating the foreign currency crisis. Malawi was in a tailspin.

In early April 2012, Mutharika had a massive heart attack. He was rushed to the hospital in the capital Lilongwe, but ironically, the medicines that he needed were out of stock the hospital lacked the foreign currency to buy them! Mutharika died. Despite considerable opposition from Mutharika supporters who wanted his brother to succeed him, Joyce Banda, the vice president, was sworn in as president. Although no one has stated this publicly, it seems clear that intense diplomatic pressure from the United Kingdom and the United States persuaded Mutharika's supporters to relent. Once in power, Banda announced that Malawi would devalue the kwacha by 40 percent. For its part, the IMF unblocked its loan program, while foreign donors, including the UK and the United States, stated that they would resume their programs.

Case Discussion Question (Answer must be no less than 250 words)

Why did the IMF recommend that the currency be devalued?

Read the closing case and post a substantive answer to question below

When the former World Bank economist Bingu wa Mutharika became president of the East African nation of Malawi in 2004, it seemed to be the beginning of a new age for one of the world’s poorest countries. In land-locked Malawi, most of the population subsists on less than a dollar a day. Mutharika was their champion. He introduced a subsidy program for fertilizer to help poor farmers and gave them seeds. Agricultural output expanded, and the economy boomed, growing by 7 percent per year between 2005 and 2010. International donors loved him, and aid money started to pour in from the United Kingdom and the United States. By 2011, foreign aid was accounting for more than half of Malawi’s annual budget.In 2009, to no one’s surprise, Mutharika was reelected president. Then things started to fall apart. Mutharika became increasingly dictatorial. He pushed aside the country’s central bankers and ministers to take full con-trol of economic policy. He called himself “Economist in Chief.” Critics at home were harassed and jailed. Independent newspapers were threat-ened. When a cable from the British ambassador describing Mutharika as “autocratic and intolerant of criticism” was leaked, he expelled the British ambassador. Britain responded by freezing aid worth $550 million over four years. When police in mid-2011 killed 20 antigovernment protestors, other aid donors withdrew their support, including most significantly the United States. Mutharika told the donors they could go to hell. To com-pound matters, tobacco sales, which usually accounted for 60 percent of foreign currency revenues, plunged on diminishing international demand and the decreasing quality of the local product, which had been hurt by a persistive drought.By late 2011, Malawi was experiencing a full-blown foreign currency crisis. The International Monetary Fund urged Mutharika to devalue the kwacha, Malawi’s currency, to spur tobacco and tea exports. The kwacha was pegged to the U.S. dollar at 170 kwacha to the dollar. The IMF wanted Malawi to adopt an exchange rate of 280 kwacha to the dollar, which was closer to the black market exchange rate. Mutharika refused, arguing that this would cause price inflation and hurt Malawi’s poor. He also refused to meet with an IMF delegation, saying that the delegates were “too junior.” The IMF put a $79 million loan program it had with Malawi on hold, further exacerbating the foreign currency crisis. Malawi was in a tailspin.In early April 2012, Mutharika had a massive heart attack. He was rushed to the hospital in the capital Lilongwe, but ironically, the medicines that he needed were out of stock—the hospital lacked the foreign cur-rency to buy them! Mutharika died. Despite considerable opposition from Mutharika supporters who wanted his brother to succeed him, Joyce Banda, the vice president, was sworn in as president. Although no one has stated this publicly, it seems clear that intense diplomatic pressure from the United Kingdom and United States persuaded Mutharika’s supporters to relent. Once in power, Banda announced that Malawi would devalue the kwacha by 40 percent. For its part, the IMF unblocked its loan program, while foreign donors, including the UK and United States, stated that they would resume their programs.

1. Now that Malawi’s currency has been devalued, what do you think the economic consequences will be? Is this good for the economy?

Read the closing case and post a substantive answer to question below

When the former World Bank economist Bingu wa Mutharika became president of the East African nation of Malawi in 2004, it seemed to be the beginning of a new age for one of the world’s poorest countries. In land-locked Malawi, most of the population subsists on less than a dollar a day. Mutharika was their champion. He introduced a subsidy program for fertilizer to help poor farmers and gave them seeds. Agricultural output expanded, and the economy boomed, growing by 7 percent per year between 2005 and 2010. International donors loved him, and aid money started to pour in from the United Kingdom and the United States. By 2011, foreign aid was accounting for more than half of Malawi’s annual budget.In 2009, to no one’s surprise, Mutharika was reelected president. Then things started to fall apart. Mutharika became increasingly dictatorial. He pushed aside the country’s central bankers and ministers to take full con-trol of economic policy. He called himself “Economist in Chief.” Critics at home were harassed and jailed. Independent newspapers were threat-ened. When a cable from the British ambassador describing Mutharika as “autocratic and intolerant of criticism” was leaked, he expelled the British ambassador. Britain responded by freezing aid worth $550 million over four years. When police in mid-2011 killed 20 antigovernment protestors, other aid donors withdrew their support, including most significantly the United States. Mutharika told the donors they could go to hell. To com-pound matters, tobacco sales, which usually accounted for 60 percent of foreign currency revenues, plunged on diminishing international demand and the decreasing quality of the local product, which had been hurt by a persistive drought.By late 2011, Malawi was experiencing a full-blown foreign currency crisis. The International Monetary Fund urged Mutharika to devalue the kwacha, Malawi’s currency, to spur tobacco and tea exports. The kwacha was pegged to the U.S. dollar at 170 kwacha to the dollar. The IMF wanted Malawi to adopt an exchange rate of 280 kwacha to the dollar, which was closer to the black market exchange rate. Mutharika refused, arguing that this would cause price inflation and hurt Malawi’s poor. He also refused to meet with an IMF delegation, saying that the delegates were “too junior.” The IMF put a $79 million loan program it had with Malawi on hold, further exacerbating the foreign currency crisis. Malawi was in a tailspin.In early April 2012, Mutharika had a massive heart attack. He was rushed to the hospital in the capital Lilongwe, but ironically, the medicines that he needed were out of stock—the hospital lacked the foreign cur-rency to buy them! Mutharika died. Despite considerable opposition from Mutharika supporters who wanted his brother to succeed him, Joyce Banda, the vice president, was sworn in as president. Although no one has stated this publicly, it seems clear that intense diplomatic pressure from the United Kingdom and United States persuaded Mutharika’s supporters to relent. Once in power, Banda announced that Malawi would devalue the kwacha by 40 percent. For its part, the IMF unblocked its loan program, while foreign donors, including the UK and United States, stated that they would resume their programs.

1. Now that Malawi’s currency has been devalued, what do you think the economic consequences will be? Is this good for the economy?