Cryptocurrencies could constrain a country’s choices (Live Mint)

Mains Paper 3: Economy
Prelims level: Bitcoins, Libra
Mains level: Cryptocurrency and impact on monetary policies

Context

• There was news of Facebook launching a cryptocurrency called Libra, designed to appeal to its global user base of over 2 billion.
• Unlike Bitcoin, which is a roller coaster, Libra will be backed by a basket of fiat currencies.

The trilemma of monetary policy

• International economics has a concept called the “impossible trinity" or the “trilemma" of monetary policy.
• It was first defined (independently) by economists John Fleming and Robert Mundell in the early 1960s.
• It states that it is impossible to have all three of the following conditions fulfilled at the same time:
• (1) a fixed foreign exchange rate,
• (2) free capital movement (that is, an absence of capital controls) and
• (3) an independent monetary policy (which controls domestic money supply, mainly through an interest-rate regime).
• The trilemma is a theory based on the “uncovered interest rate parity condition" and is supported by evidence-based studies where governments that have tried to simultaneously pursue all three goals have failed.
• The uncovered interest rate parity condition means that if a dollar can only fetch a 1% rate of return in the US, but say 6% in India (at the same levels of risk), investors are bound to move from dollars to rupees.
• The reason they don’t is that the differential of 5% will likely reduce to zero as a result of a slide in the rupee’s value to the extent of its current interest differential against the dollar.

Way forward

• Strong capital controls have meant that other means of payment have been in use before, such as the infamous “hawala" system. Law enforcement agencies track these down relentlessly.
• However, the ease of use and the scope of new Big-Tech cryptocurrencies are about to create global currencies of a completely different class.
• The economists begin with a model that considers a two-country system.
• Both use their own national currencies as well as a global cryptocurrency.
• Assuming markets are efficient and complete, and that the global cryptocurrency is freely used in both countries, they show that the interest rates in both countries must necessarily be equal, and that the exchange rate between the two countries becomes what is termed a “martingale".
• A martingale is a sequence of variable numbers where the next number in the sequence, given all prior numbers, is most likely the same as the present value.
• Simply put, it means that the best predictor of tomorrow’s value would be today’s value.

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Prelims Questions:

Q.1) Which of the following statements is/are correct about NASA’s ICESat-2?
1. It aims to measure the width of icy particles on the planets in the Kuiper belt.
2. Researchers are going to use the information to study sea level rise resulting from melting ice sheets and glaciers, and to improve sea ice and climate forecasts.

Select the correct answer using the code given below:
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Correct Answer: B
Mains Questions:
Q.1) Discuss about the trilemma of monetary policy. How cryptocurrencies can regulate through this kind of policy?