Questions: International Monetary Cooperation and Exchange Rates

Question 1

A small open economy pegs its currency to a major trading partner's currency and allows full capital mobility for foreign investors. According to the Impossible Trinity, what must it sacrifice?

• A. The ability to engage in international trade
• B. Independent domestic monetary policy
• C. Membership in the International Monetary Fund
• D. The ability to run a current account surplus

Answer: (B)

The Impossible Trinity states that a country can have at most two of: fixed exchange rate, free capital mobility, and independent monetary policy. With a fixed exchange rate AND free capital mobility, any attempt to set interest rates differently from the anchor country triggers capital flows — inflows if domestic rates are higher, outflows if lower — that create exchange rate pressure requiring the central bank to defend the peg by adjusting rates back. Monetary independence is thereby eliminated. This is why eurozone members (effectively fixed rates, full capital mobility) cannot set their own interest rates.

Question 2

The 'exorbitant privilege' of dollar hegemony refers to the United States' ability to:

• A. Set the gold price for all major currencies, as established at the Bretton Woods conference
• B. Run persistent current account deficits and borrow cheaply because structural global demand for dollars is guaranteed by network effects and US power
• C. Exercise veto power over all IMF lending decisions through its weighted voting share
• D. Prevent other countries from floating their exchange rates against the dollar

Answer: (B)

Because the dollar is the dominant global reserve currency, commodity-pricing unit, and denomination for international debt, the world continuously demands dollars — which means the US can run current account deficits without a balance-of-payments crisis, borrow at lower rates than otherwise warranted, and conduct monetary policy that shapes global financial conditions without global accountability. Giscard d'Estaing coined the phrase to protest that this advantage is structural — sustained by network effects, financial infrastructure, and US power — not earned by market efficiency.

Question 3

Countries that allow their exchange rates to float freely have no need for international monetary cooperation.

• T. True
• F. False

Answer: False

Even floating-rate systems require cooperation. States must coordinate to prevent competitive devaluations (deliberately weakening currencies to gain export advantages at others' expense), manage financial crises that cross borders, and provide emergency liquidity when countries lose market access. The 2008 global financial crisis required unprecedented central bank swap lines and IMF interventions among floating-rate economies. The Impossible Trinity determines the form of cooperation needed, not whether cooperation is needed at all.

Question 4

The Bretton Woods system collapsed partly because the United States accumulated more dollar liabilities globally than it held gold reserves to back them.

• T. True
• F. False

Answer: True

This is the Triffin dilemma: to supply the world with dollars for trade and reserves, the US had to run balance-of-payments deficits. But the growing global stock of dollar claims eventually far exceeded US gold holdings at the $35/oz peg. By the late 1960s, other countries held more dollar claims than the US could redeem in gold, making convertibility impossible to sustain. Nixon's 1971 closure of the 'gold window' — ending dollar-gold convertibility — was the structural consequence of this internal contradiction.

Question 5

Explain the Impossible Trinity and why a country cannot simultaneously maintain a fixed exchange rate, free capital mobility, and independent monetary policy.

Model answer: The Impossible Trinity holds that a country can achieve at most two of these three goals simultaneously. The mechanism: with a fixed exchange rate AND free capital mobility, any interest rate set differently from the anchor country will trigger capital flows — inflows if domestic rates are higher (currency pressure upward), outflows if lower (pressure downward) — forcing the central bank to defend the peg by returning rates toward the anchor, eliminating policy independence. Any two can coexist, but the third must be sacrificed.

Historical examples illuminate each vertex of the trilemma. Bretton Woods chose fixed rates plus monetary independence by restricting capital flows. The eurozone chose fixed rates (a common currency) plus capital mobility by surrendering monetary independence to the ECB. The US and UK choose capital mobility plus monetary independence by letting exchange rates float. Understanding the trilemma explains why monetary cooperation always involves negotiating which constraint to accept, and why no arrangement can satisfy all three goals at once.