RBI AND THE IMPOSSIBLE TRINITY

BY GROUP D2 AJAY KUMAR VERMA ANUSHA JOHN RUCHI GUPTA SAGAR SAXENA SUMIT AGARWALA

‡ Introduction ‡ Impossible Trinity

FLOW OF PRESENTATION 

Capital Mobility  Exchange Rate  Monetary Policy or Fiscal Policy

‡ Why should RBI deal with Impossible Trinity ‡ Managing Capital Mobility 
Reasons for rising capital inflows  Managing Capital flows

‡ Managing Foreign Exchange Rate ‡ Managing Monetary Policy ‡ Conclusion

INTRODUCTION
‡ Pre 1990 Fiscal dominance and associated Financial Repression ‡ Post 1990  Regulated Economy Growing Degree of deregulation and Liberalization  Fiscal dominance monetary-fiscal coordination  Exchange rate has been largely market-determined since March 1993.  The capital account has been liberalised in terms of inflows as well as outflows.  Monetary policy signals are now largely transmitted through changes in policy rates.

IMPOSSIBLE TRINITY
‡ The Impossible Trinity is the hypothesis in macroeconomics that it is impossible to have all three of the following at the same time:  Exchange rate stability  Free capital movement  An independent monetary policy. ‡ Also known as the Inconsistent Trinity, Triangle of Impossibility or Unholy Trinity

IMPOSSIBLE TRINITY

o Capital Inflows ‡ Direct Benefit Generally domestic savings not enough for development of economies Need Foreign capital ‡ Indirect Benefits  Development of domestic financial sector  Improved macroeconomic policies o Capital Outflows ‡ Benefits  People and Companies can diversify their portfolios and take advantage of growth opportunities elsewhere Flipside: Can lead to financial crisis

CAPITAL MOBILITY-FULL OR LIMITED

EXCHANGE RATE - FIXED OR FLOATING
‡ Fixed Exchange Rate Systems: Prone to crisis ‡ Floating Exchange Rate Systems: Exchange rate fluctuation driven by international speculative flows volatile ‡ Many countries opt for ´managed floating systemµ

MONETARY POLICY OR FISCAL POLICY
o Fiscal Policy ‡ Direct role: To increase output getting limited ‡ Indirect role: To enhance competition and private sector participation increasingly appreciated o Monetary policy ‡ Role: Maintaining low inflation important for sustained growth

Exchange Rate Stability

Price Stability

Growing Country (India)

Increase Investments ² Liberalize capital flows

Foreign Investors convert dollars into Rs.

Exchange Rate fixed -> Bank gives/prints desired Rs.

Demand increases > Exchange rate should appreciate Exchange Rate Stability

Demand for domestic currency increases

Supply of Rs. increases -> Inflation increases

Price Stability

WHY SHOULD RBI DEAL WITH THE IMPOSSIBLE TRINITY?
‡ The Preamble of Reserve bank of India Act 1934, "...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage.´ ‡ Three years of growth over 9%, India's economy expanded 6.7% in 2008/09 fiscal year ‡ This year projections start at 7.2%, some even believe that India can overtake China as the fastest growing nation in the world.

WHY SHOULD RBI DEAL WITH THE IMPOSSIBLE TRINITY?
‡ Significant fiscal stimulus and loose monetary policy ‡ Inflation ‡ Weaker monsoon has pushed cost of food significantly higher ‡ The magnitude of capital flows has become quite large and if not managed properly, would lead to instability in the economy.

MANAGING CAPITAL MOBILITY
‡ BENEFITS 
Financing Investment  Economic growth

‡ PROBLEMS 
Push up money aggregates  Inflationary pressures  Destabilize exchange rate  Affect domestic financial sector

RISING CAPITAL INFLOW
‡ Indian economy was growing at 8.5% plus from 2004 to 2008. ‡ Interest rate cut by the central Banks in developed economies. ‡ Need to build infrastructure capacities in the country.

MANAGING CAPITAL FLOWS
‡ Restricting capital flows ² credibility ‡ The best way to absorb huge capital inflows is to strengthen the financial system. ‡ The RBI has actively withdrawn liquidity from the system. ‡ Some restrictions on capital inflows have recently been introduced, primarily on corporate borrowing.

MANAGING FOREIGN EXCHANGE RATE
‡ Predominant objective - Flexible exchange rate ‡ The exchange rate policy is guided by the need to  reduce excess volatility  prevent the emergence of destabilising speculative activities  help maintain an adequate level of reserves  develop an orderly foreign exchange market

MANAGING MONETARY POLICY
‡ Domestic demand remains the key driver of economic activity ‡ Monetary and credit aggregates was broadly in line with demands of the real economy ‡ Monetary policy was conducted with a view to ensuring not only price stability but also financial stability.

CONCLUSION
‡ Key elements of RBI·s policy have been  Active management of the capital account, especially debt flows  Flexibility in exchange rate movements but with capacity to intervene in times of excessive volatility;  Treating capital flows as largely volatile unless proven otherwise  Building up of adequate reserves  Sterilisation of interventions in the foreign exchange market through multiple instruments, including cash reserve requirements Monetary policy needs to move away from narrow price stability/inflation targeting objective.

‡

REFERENCES
‡ ´Exchange Rate Policy and Modelling in Indiaµ by Pami Dua and Rajiv Ranjan ‡ Working Paper No. 401- ´Managing the Impossible Trinity:Volatile Capital Flows and Indian Monetary Policyµ By Rakesh Mohan and Muneesh Kapur ‡ Reddy, Y.V., 2008, ´Management of the Capital Account in India: Some Perspectivesµ, Reserve Bank of India Bulletin, February. ‡ ´RBI and Impossible trinityµ Amol Agrawal ‡ http://www.imf.org/external/pubs/ft/survey/so/2008/CAR024 08A.htm ‡ http://www.tradingeconomics.com/Economics/GDPGrowth.aspx?Symbol=INR ‡ http://www.investopedia.com

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