The Mundell Triangle’s Application to Hong Kong

Introduction

Since the world fell into a global financial crisis, between 2008 and 2009, there have been efforts by the economists and policy makers to find the way forward in terms avoiding such an occurrence in future. The prevailing international monetary system has been the focus of criticism by many experts in the field, citing major weaknesses that render it ineffective in understanding the economic reality of individual and the global economies (Mishkin 62). The modern economic system has remained a uni-currency one with a strong reliance on the U.S. dollar as the standard for the exchange rate. The dollar is also the major contributor to the global crisis, explaining why the criticism has been labeled against it (Aizenman and Ito 2). As the international reserve, the US dollar is used in understanding the reality of domestic economic systems. The strength of local currencies is measured against the dollar. Among the major models that have emerged in explaining the international economic system is the Mundell triangle. With a major focus on Hong Kong, which is a fixed exchange rate regime, the Mundell triangle can be used in understanding the economic conditions of a nation.

The Mundell Triangle

Evidently, the economic performance of the international economic system has grown in complexity. As a result, policy makers are facing the theoretical limitation known as the “impossible trinity” or “trilemma” (Aizenman and Ito 2). The theory was proposed in 1963 by Mundell. According to this theoretical model, it is not possible for a country to fulfill three of the conditions suggests at the same time. Hence, a country can only choose two out of the three (Mundel 3). The three conditions are stability of the exchange rate, monetary independence, and free capital flow (economic integration). Indeed, this is because of the incompatibility of the three conditions. The model is useful as it provides a clear understanding of the constraints and challenges that are faced by policy makers in the open economic environment (Aizenman 11). The hypothesis is referred to as the policy because of the limitation in choosing the economic conditions to fulfill. The figure 1 below shows the pictorial presentation of the impossible trinity.

(Figure 1: The Economist, para 3)

If, for instance, a country chooses a fixed value of the currency and has an economy that is closed, it is not possible to have free flow of the economy. Again, a country can maintain an exchange rate that is fixed and allow capital to flow freely within it, which means that there is no room for monetary independence. In a country that capital is flowing freely and there is room for monetary independence, it means that its currency cannot be fixed, but should be a floating one. It has been posited that policy makers who have tried to pursue the three conditions at the same time have never succeeded (Aizenman 11). The international system is set out in such a way that only two conditions can be effectively achieved. Hence, policy makers should carefully consider the goals that the economic structure of the company can allow and that which can present the best possible outcomes.

HK’s Fixed Rate

Hong Kong is a typical example of a fixed or linked exchange rate system. This means that the exchange rate of the economy is pegged to the currency of another country (the US in this case). Professor Y.C. Jao, the Honorary Vice-President at the University of Hong Kong, is the brain behind the implementation of this economic arrangement. The move was undertaken following the 1983 Black Saturday crisis. The certificates of indebtedness’ redemption were released during the time. The notes had the requirements for the banks in the country to link the local dollar against the US dollar. This became the basis for the introduction of the fixed external rate of HKD 7.80 = USD 1. The de facto central bank in the country, Hong Kong Monetary Authority (HKMA) guaranteed the exchange of HKD into USD and the other way round (Auboin 5). This would be done at the fixed rate of 7.80 regardless of any changes in the economic conditions of the country or the global economy.

To address potential issues emanating from global market rate below the fixed exchange rate, the USD would be converted for HKD which would allow an increase in the local currency. At the same time, it would achieve an increase in the market rate back to the fixed exchange rate, hence stabilizing the currency. In the case of an opposite scenario, the market rate being greater than the fixed exchange rate, the local currency is converted into USD. The regime was implemented with the aim of stabilizing the exchange rate between its local currency and the US dollar. The exchange rate stability has been evidenced for the last 3 decades. The trade-dependent economy has been using the US dollar for its importations and exportations (Auboin 5). The peg has made it possible for businesses to perform estimations of the cost as well as establish the pricing for their goods and services. This is because those doing business in the country are free from the worries resulting from fluctuations in the exchange rate. It is also possible to save the cost to hedge against volatility in the exchange rate.

The application of nominal exchange rate movements is ruled out by the linked exchange rate regime in the country. This means that the mechanism is not applicable in adjustment of the exchange rate system. Therefore, the cost/price structure of the country is expected to undergo major adjustments compared to a situation where there is freedom for the rate to change when there is close alignment between the two countries. Nonetheless, these kinds of adjustments are slower compared to fast ones in an environment of floating exchange rate. Hence, the effects on the economic performance of the fixed exchange rate have been different in the environment of fixed exchange rate amid an open economic system (Mishkin 436). The long term economic performance of the country has been stable because of the stability emanating from fixing the exchange rate. Hence, there is no doubt that the country remains one of the best performers in terms of the economic development and stability in the global financial system.

Analysis of HK Conditions

In the general equilibrium model (the policy trilemma) it is evident that in both floating and fixed exchange rate systems, the monetary policy can work as long as capital is not flowing freely in and out of the country. Nonetheless, in the event that there is capital flowing freely, the monetary policy works well where the economic system uses a floating exchange rate. Hence, fixed exchange rate does not work well under a fixed exchange rate regime. The policy makers in Hong Kong chose to adopt a fixed exchange rate and free flow of capital, which means that it has to give up monetary independence (Chaoyang & Hung 2). The idea is that the country has given up its monetary policy, following the policy point of view. The choice of the side of the triangle is based on the importance of ensuring a stable rate of exchange for effectiveness in risk management and to better its trade, which is the basis for its economy. To maintain the economic and social stability amid the openness to international trade, it was necessary to maintain a stable rate of exchange.

Using this financial model, the HKMA is effective in buying and selling the local currency for the international one at the fixed rate to ensure the stability of the economy. From the perspective of the policy trilemma, the LM* curve is shifted by the central bank as necessary to maintain e (exchange rate) at the pre‐announced rate. The system has a fixed nominal exchange rate. Essentially, when there is flexibility in the prices, there can be movement of the exchange rate as long as the nominal remains constant. In the event that a country maintains a floating exchange rate regime, at changing output, there is an ineffective financial policy (Klein and Shambaugh 34). On the other hand, if the exchange rate is fixed, under the same conditions, there is a highly effective financial policy (see figure 2 below).

(Figure 2: Farhi and Werning 5)

The resulting equation is:

There was a complete abandonment of a monetary policy since the implementation of the linked exchange rate regime in the country. The exchange rate for the country can float, but very slightly between 7.75 and 7.85. Hence, it means that regardless of the internal or external conditions changing, the rate of exchange in the country is not affected. Also, given that the economy allows mobility of capital in and out, the fiscal autonomy is not possible. Evidently, it is only the dollar rate of the country that does not allow changes (Chaoyang & Hung 2). The USD, on the other hand, is affected by factors internal to the country and those inherent within the international financial system. Hence, the country is not allowed financial independence, explaining why it has abandoned a financial policy. The reality is that the dollar interest rate in Hong Kong is dependent upon the United States (Klein and Shambaugh 34). Regardless, there has been economic stability in the country in the period within which the system has been in use. An automated interest rate adjustment technique is used in the country to ensure the stability of the exchange rate.

Through the use of the Mundell triangle, there is an important explanation of the economic stability experienced in Hong Kong in the last few decades. The economic decisions made in the country by the policy makers are biased towards the left side (the A side of the triangle). This means that despite the shakes within the global economic system, the system is capable of regulating itself such that the exchange rate is not negatively affected. In the process, the economic stability continues to attract more capital flow into the country (Farhi and Werning 5). In fact, it is revealed that Hong Kong is one of the countries that have been able to attract the most capital flow following the global financial crisis. The prices of residential property went up four-fold beginning from 2003 and maintained a number of years of high inflation. The peak was experienced between 2011 and 2014 (Chaoyang & Hung 3). Figure 3 below shows the changes in housing prices as an impact on the financial system pursued in the country.

(Figure 3: Delmendo para 1)

However, the analysis also points that the reality goes hand in hand with more robust as well as critical structural adjustments in the actual economic activity.

Conclusion

The analysis of the global economic system is never an easy task because of the complexity of the system. Economists and policy makers have made huge steps in coming up with the frameworks and models for the analysis of the international economic system. Among the models is the Mundell triangle as popularly known because of the dilemma involved in its application to financial policy. From the perspective of this model, it is not possible to meet the three conditions in the same economic environment and at the same time. The conditions, foreign exchange rate, free flow of capital, and financial autonomy, cannot be pursued together. Only two of the three can be achieved. In the case of Hong Kong, the two are fixed rate of foreign exchange and free flow of capital. The exchange rate has been fixed at 7.8 against the USD and has led to major stability in the economic performance of Hong Kong. From research, it is evident that policy makers are not keen to reform the system anytime soon because of the inherent benefits.