US urges China to Ease Exchange Rate Controls

According to the Impossible Trinity Theorem, an economy cannot simultaneously have free capital mobility, fixed exchange rate and independent interest rate centred monetary policy. In other words, an economy open to capital flows (i.e. hot money, FDI) will have to choose between a regime of controlling interest rate OR exchange rate.

Currently, China is independently controlling interest rates and exchange rates due to restrictions on capital flows. That is, China is not an economy open to capital flows. If China were to ease control over exchange rate controls, China will eventually gravitate towards a floating exchange rate regime, free capital mobility and independent interest-rate centred monetary policy. This development could be decades away because China is still reliant on external demand and hence needs to maintain control over exchange rate.

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