The Impossible Trinity and Dilemma of

Nepals Monetary Policy

The impossible trinity is achieving three things at the same time: exchange rate
stability, free fow of
international capital and an autonomous monetarypolicy (which means the ability
to target infation and/
or interest rates). t is not possible for straightforward reasons: if capital is free to
move in and out, and the
exchange rate is !xed, then money can swing in and out in huge "uantities and
play havoc with domestic
infation and interest rates # which then rules out an autonomous monetary policy.
$imilarly if interest rate
is targeted, monetary aggregates might move beyond desired level (depending
upon interest elasticity of
money or credit demand) having its implication for external sector balances. n a
perfectly open economy
case, excess or de!cient money supply would then change the course of capital
fows, ultimately
thwarting the target of interest rate level.n developing countries, monetary policy
has
become increasingly important in recent years, even though capital accounts have
been progressively
liberali%ed. The reason is that the large movements in global capital during the late
&''(s forced many
of these countries to abandon !xed or closely managed exchange rate regimes.
$uch recent
developments have put a new face on an older, deeper lesson: namely that freely
mobile capital,
independent monetary policy, and !xed exchange rates form an impossible trinity.
t is opined that it is
possible to have any two of these policies, but not all three.
There is a view that real interest rate has to be positive in order to encourage
!nancial savings
mobili%ation. $o there is a temptation to control interest rate along with targeting
monetary aggregates.
Targeting an infation of less than ) per cent and attempting to maintain interest
rate at a level close to
that in ndia means that both interest rates and money supply have to be at the
disposal of the authorities.
n a mar*et related monetary and !nancial structure, this cannot be attained
through direct interventions
Ta*e the exchange rate case next. The central ban* has traditionally tried to
defend the peg with ndian
currency. That policy still holds, which means that the central ban* wants one of
the legs of the trinity:
stable exchange rates. +t a time of high capital fows, more fre"uent interventions
have to be made to
defend the current peg. ,on-sterili%ed interventions in the foreign exchange
mar*et then have serious
implications for monetary aggregates which impinge upon prices and balance of
payments.
Tal*ing about the third aspect of the impossible trinity that is free fow of capital,
,epal has so far
loosely maintained capital control. .ut institutional capital fows mainly through
the ban*ing system and
from the private sector individuals towards ndia remains unregulated. Thus, if the
domestic rupee is
ruling stronger than what the central ban* would li*e, and if there is cross border
di/erence in interest rates
even in !xed exchange rate regime, there is a possibility of strong capital fows
from/to the
country which would a/ect directly the exchange rate or would indirectly a/ect
the same through the
balance of payments. n an economy with shallow domestic !nancial
system and high potential for capital fows, monetary targeting for infation control
and exchange rate
targeting to defend the peg would be a di/icult tas* for the central ban*. n the
similar vain, defending a
peg would imply a loss of autonomy in monetary operation. This means that ,0.
has perhaps some
times in future to ma*e a hard choice between brea*ing the peg and loosing
monetary autonomy