TRILEMMA OF INTERNATIONAL MACROECONOMICS Policy makers have
three desirable goals: 1. Stable exchange rate (promotes trade and foreign
investment). 2. Independent monetary policy (provides tools to manage the
business cycle). 3. Free capital movements (promotes integration, efficiency,
and risk sharing).
Trilemma impossible to achieve all three goals at the same time.
CHOOSING TO FIX EXCHANGE RATE: PROS/CONS
∗ Peg domestic currency to foreign one.
∗ Promotes stability in trade and investment (limits foreign exchange risk)
∗ Strict limits on ability to conduct monetary policy.
∗ Unless it shuts down foreign exchange market.
EXAMPLES OF TRILEMMA
Countries next to the euro zone:
∗ Trade with eurozone important and they therefore need stable exchange
∗ Can either peg, abandon monetary independence, float and keep
∗ Allowing wider band around pegs create opportunity for some
∗ Depend heavily on exports to US and need stable exchange rate with
∗ Cannot accept US monetary policy (different economies).
∗ Their solution: strict capital controls.
Past US exchange rate regimes
∗ Gold Standard (free capital mobility, no monetary independence 19-20
cent.) and Bretton Woods (post WWII-early 70s, no capital mobility,
independent monetary policy) were also systems of pegs.
∗ Currently the US chooses capital mobility and monetary independence:
volatility of exchange rate.
WHY PRICES ARE HIGHER IN DEVELOPED COUNTRIES: BALASSA-
Countries: Home and Foreign. Goods: Traded and Non-traded
Good T has the same price in both countries.
Pt=1 Workers can produce either good but cannot move between
PRODUCTIVITY, WAGES, AND PRICES
- A worker in Home country makes A units of T in an hour. His wage is $A.
- Worker in Foreign country makes A* of I in an hour Ew*=A*
- Productivity in making the non-traded good =1
- Worker in either country can produce one unit of good N in an hour.
Price of N
PREDICTIONS OF THE BALASSA-SAMUELSON MODEL
Countries with more productive traded-goods industries have higher wages and