trilemma which emerges from the standard Mundell-Fleming model many of us still teach our undergraduates.
In their words, the chosen macroeconomic policy regime can include at most two elements of the “inconsistent trinity” of three policy goals:
(i) full freedom of cross-border capital movements;
(ii) a fixed exchange rate; and
(iii) an independent monetary policy oriented towards domestic objectives.
The proof of this proposition is straightforward: capital mobility vis-à-vis the rest of the world implies uncovered interest parity; uncovered interest parity combined with fixed exchange rates implies that domestic interest rates are pinned down by interest rates abroad. A country with open capital markets which maintains a fixed exchange rate system thus loses the freedom to vary domestic interest rates in order to pursue domestic policy objectives.