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Alternatively, Austria could maintain freedom of private capital movement but allow the schilling/mark rate to float. In that case, Austria would be free to lower its interest rates, but the schilling would depreciate against the mark as a result. Both developments would tend to spur aggregate demand for Austrian output.

The limitations that open capital markets place on exchange rates and monetary policy often are summed up by the idea of the “inconsistent trinity” or, as Alan Taylor and I have labeled it, the “open-economy trilemma” (Obstfeld and Taylor, 1998): that is, a country cannot simultaneously maintain fixed exchange rates and an open capital market while pursuing a monetary policy oriented toward domestic goals. Governments may choose only two of the above. If monetary policy is geared toward domestic considerations, either capital mobility or the exchange rate target must go. If fixed exchange rates and integration into the global capital market are the primary desiderata, monetary policy must be subjugated to those ends.

The choice between fixed and floating exchange rates should not be viewed as dichotomous. In reality, the degree of exchange-rate flexibility lies on a continuum, with exchange-rate target zones, crawling pegs, crawling zones, and managed floats of various other kinds residing between the extremes of floating and irrevocably fixed. Indeed, the notion of a “free” float is an abstraction with little empirical content, as few governments are willing to set monetary policy without some consideration of its exchange-rate effects. However, the greater the attention given to the exchange rate, the more constrained monetary policy is in pursuing other objectives.