RBI AND THE IMPOSSIBLE TRINITY BY GROUP D2

AJAY KUMAR VERMAANUSHA JOHNRUCHI GUPTA

SAGAR SAXENASUMIT AGARWALA

FLOW OF PRESENTATION• Introduction

• Impossible Trinity 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 stabilityFree capital movementAn independent monetary policy.• Also known as the Inconsistent

Trinity, Triangle of Impossibility or Unholy Trinity

IMPOSSIBLE TRINITY

CAPITAL MOBILITY-FULL OR LIMITED

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 policieso Capital Outflows• Benefits People and Companies can diversify their

portfolios and take advantage of growth opportunities elsewhereFlipside: Can lead to financial crisis

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 system”

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

Growing Country(India)

Increase Investments –

Liberalize capital flows

Foreign Investors convert dollars

into Rs.

Demand for domestic currency increases

Demand increases -> Exchange rate should appreciate

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

Supply of Rs. increases ->

Inflation increases

Price Stabilit

y

Exchange Rate Stability

Exchange Rate Stability

Price Stabilit

y

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

• BENEFITSFinancing InvestmentEconomic growth

• PROBLEMSPush up money aggregatesInflationary pressuresDestabilize exchange rateAffect 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 – 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 volatilityprevent the emergence of

destabilising speculative activitieshelp maintain an adequate level of

reservesdevelop 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 India” by

Pami Dua and Rajiv Ranjan• Working Paper No. 401- “Managing the Impossible

Trinity:Volatile Capital Flows and Indian Monetary Policy” By Rakesh Mohan and Muneesh Kapur

• Reddy, Y.V., 2008, “Management of the Capital Account in India: Some Perspectives”, Reserve Bank of India Bulletin, February.

• “RBI and Impossible trinity” Amol Agrawal• http://www.imf.org/external/pubs/ft/survey/so/200

8/CAR02408A.htm• http://www.tradingeconomics.com/Economics/GDP

-Growth.aspx?Symbol=INR• http://www.investopedia.com