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The “Impossible Trinity” and India’s Monetary Policy Challenge

(SYLLABUS RELEVANCE: GS 3: Indian Economy)

Why is it in the news?

  1. The Impossible Trinity or trilemma has come under focus recently as the U.S. Federal Reserve has been raising interest rates to fight rising prices.
  2. IThe idea was proposed independently by Canadian economist Robert Mundell and British economist Marcus Fleming in the early 1960s.

The Concept of the impossible trinity or trilemma

An economy cannot pursue all three simultaneously:

  1. Independent monetary policy.
  2. Fixed exchange rate.
  3. Free flow of capital across borders.

Practical Choices for Policymakers

In today’s globalized world with easy capital movement, policymakers must choose between:

a) Maintaining a fixed exchange rate

# If policymakers peg their currency’s value, it limits their monetary policy options.

# Tightening monetary policy may be necessary to maintain currency strength.

# Loose monetary policy can pressure the currency to depreciate.

b) Pursuing independent monetary policy

# Independent monetary policy can affect exchange rates.

# Easy monetary policy may lead to currency depreciation.

# Hence, Central banks may need sufficient foreign reserves to defend their currency.

Historical Context

  1. In the past, capital controls allowed more flexibility.
  2. Capital controls regulated capital flow to stabilize exchange rates.
  3. Capital controls, though effective, hindered economic growth.

Current Trilemma

  1. U.S. Federal Reserve’s interest rate hikes have affected global capital flows.
  2. Investors move funds to the U.S. for higher yields, pressuring other currencies.
  3. Example of Japan and its currency depreciation due to its monetary policy stance.
  4. Reserve Bank of India (RBI) faces pressure on the rupee due to Fed rate hikes.
  5. Rupee depreciation and RBI’s response to price rise and the potential choice between defending the rupee and domestic demand.

Impact of China’s Economic Situation

  1. China experiences deflation, rate cuts, and yuan depreciation.
  2. INR appreciates against the Chinese yuan.
  3. Cheaper yuan makes Chinese exports more competitive, affecting India’s domestic market.

Capital control measures

  1. India attempts to curb capital outflows.
  2. Import bans and license-based import policies implemented.
  3. Tax rate on outbound remittances increased from 5% to 20%.
  4. Concerns about supply-pull inflation due to import restrictions.

Investment Strategies

Opportunities for Indian investors:

  1. Investing in domestic companies earning in dollars (IT and Pharma sectors).
  2. Diversifying investments abroad to hedge against rupee depreciation.
  3. Potential benefits from INR-USD arbitrage gains.

Conclusion

  1. India’s policymakers and investors face a complex economic landscape.
  2. Adapting to the trilemma’s constraints and the evolving global financial situation is crucial for long-term stability and growth.

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