The impossible trinity

If you happen to be a central bank - dilemma is long passé; trilemma is the new reality of the financially liberalised world. Back home, the Reserve Bank of India (RBI) has been caught in the ‘impossible trinity’ trilemma where it has to tackle three concerns all at once — free capital flows, stable exchange rate, and independent monetary policy.

What is the ‘impossible trinity’ ? The trilemma propped up in the context of the Mundell-Fleming Model developed in the 1960s which analysed the effectiveness of monetary policy in an open economy (free capital movement) under different exchange rate regimes.

A central bank may find it difficult to pursue all three targets at the same time and has to pick any two.

Let’s take the example of a central bank that decides to follow a tight monetary policy, raising interest rates to keep a check on inflation. With higher interest rates in the home country, foreign investors will be attracted to invest , in turn leading to an appreciation of the home currency.

Now, if the central bank decides to intervene and control the volatility in the exchange rate, it may start to negate the effect of its monetary policy .

That is, the central bank’s conduct of the monetary policy is not independent of exchange rate management, given that capital is freely mobile. Thus in the face of free capital flows , it has to let the currency finds it own way.

On the other hand, if the central bank decides to pursue an independent monetary policy, as well as manage exchange rates, then controls will have to be imposed on foreign capital flows. This is because with a change in domestic interest rates relative to the rates prevailing internationally, foreign investors will move in and out of the country with consequent implications for the domestic currency.

While some countries work within this framework, others including India try to find a solution mid-way. India is open to foreign capital flows but subject to certain restrictions.

Again the exchange rate is largely market determined, with intermittent intervention to reduce currency volatility.

However this may limit the independence on the monetary policy to some extent.

RBI’S TRILEMMA

During the last few months as the rupee began its free fall, the RBI stepped in with a host of measures to suck out liquidity. It seemed convinced that such excess liquidity was used to speculate in the currency markets.

If it weren’t for the plunging rupee, the RBI would have been stuck with its earlier ‘dilemma’ of reviving growth and containing inflationary pressures.

But as it shifted its focus to managing the exchange rate, the monetary policy now had to juggle with yet another issue.

With some of the currency concerns receding, the RBI has now eased some of the liquidity tightening measures in its latest monetary policy review.

>maulik.tewari@thehindu.co.in

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