RBI AND IMPOSSIBLE TRINITY Introduction The RBI pursues a policy called a managed float.

. The rupee is flexible within limits but the RBI will intervene to prevent excessive fluctuations At the same the RBI seems to keep inflation low This creates a fundamental conflict in an economy with open capital flows which is often described as the impossible trinity

Managed Float An exchange rate which is flexible but where the central bank intervenes occasionally is called a managed float Reasons for central bank intervention: a) smoothing excessive fluctuations in exchange rates b) Exchange rates affect trade and aggregate demand Two main methods of influencing exchange rates: a) Direct intervention in the forex markets b) Indirect intervention through regular monetary policy which will indirectly influence exchange rates Many central banks including the RBI pursue a managed float. One major problem with this policy is that it makes monetary policy less transparent since there are two goals: keeping low inflation and managing the exchange rate.

Real effective exchange rate (REER) The REER is a measure for whether a currency is undervalued or overvalued. The RBI has used it as guide to exchange rate management. Effective means that instead of looking at a single exchange rate, a composite is created of the exchange rates of various important trading partners NEER or nominal effective exchange rate is a composite of different exchange rates of a countrys various trading partners. Real means that the exchange rate is adjusted for inflation rates in both the home country and the trading partner. After adjusting the NEER for inflation you get the REER.

 REER= NEER *(P(d)/P(f)) Where P(d) is domestic price level and P(f) is foreign price level For example if India has a higher inflation rate than its trading partners but its NEER remains constant then its REER will rise.

RBI and REER The RBI calculates a 36 country index which covers around 75% of Indias trade. The base year is1993-94 and the index uses three-year moving average trade statistics to assign weights to the different currencies. There are two sets of weights: one based on trade and one based on exports. In general the RBI has intervened in the market to keep the REER between 95 and 105.

Impossible Trinity The following three are impossible to sustain simultaneously: 1)A fixed exchange rate 2)Free capital flows 3)Independent monetary policy This creates a dilemma for policymakers since all these three are desirable for different reasons Policymakers have to choose which of the two are most important for the economy in question Either they give up completely on one of the three or they partially adjust between the three (relevant to India).

Independent Trinity

Why manage exchange rates? Flexible exchange rates too volatile and prone to overshoot. Rapidly rising exchange rates can damage export sector. No social safety net for unorganized export sector e.g. textiles. Rapidly falling exchange rates can spark inflation and damage investor confidence.

Why open capital flows? Capital flows can increase aggregate investment and raise growth rates FDI investment brings in new technology and raises technological progress and growth Foreign investment can improve institutional quality of financial markets and increase liquidity.

Why independent monetary policy? Monetary policy is the most effective tool for short-run macroeconomic stabilization Execution lag is much lower than fiscal policy. Effective monetary policy helps keep inflation low and improve investment climate as well as reduce volatility Conclusion: All three variables are desirable to an extent. Solution try to find optimal combination of 3 variables.

Hypothetical Example Think of the three legs of the impossible trinity and give them scores of 1-10: Independent monetary policy: 10 being a fully autonomous monetary policy Managed currency:10 being a fully fixed exchange rate Capital flows:10 being a fully open capital account. Then the impossible trinity says that a country can have at most a total score of around 20. One way of achieving this is to give one of the three legs completely and achieve close to full scores on the other two. Alternatively you can achieve a mix of the three: perhaps around 6 to 7 on each.

 Policymakers may change the mix according to conditions: e.g. going from 7 to 6 on capital convertibility in order to move from 7 to 8 on managed currency. Restrictions on PNs in 2007 may be viewed as an example of this.

Impossible Trinity in 2007 In 2007 the RBI seemed to hit the constraints of the impossible trinity Huge FII inflows, rising rupee RBI intervention to prevent rupee from appreciating Losing control over inflation because of overheating economy and high commodity prices

Impossible trinity in 2008 At the height of the crisis in late 2008 the RBI faced the impossible trinity in the opposite direction. Huge capital outflows because of crisis led to downward pressure on the rupee RBI intervened to prevent rupee depreciation Such intervention was contractionary in nature which was inappropriate for domestic monetary policy Once again trade-off between exchange rate management and domestic macroeconomic management

Possible solutions Sterilization: combine forex intervention with offsetting bond transaction. Problem offsetting transaction may undercut initial intervention. In general sterilization often ineffective. Issuing government bonds and interest payments impose significant fiscal cost Another solution is capital controls: e.g. restrictions on participatory notes proposed in October 2007. However such proposals can be adhoc and increase market volatility

Tobin Tax? Tobin Tax proposed by economist James Tobin: a tax on short-term currency transactions in order to reduce exchange rate volatility

 In the context of impossible trinity a similar tax would give the government a second tool to control capital inflows while still using monetary policy to focus on low inflation E.g. Brazil recently imposed a 2% tax on portfolio inflows to restrain capital inflows and prevent appreciation of its currency. Possible problems: Evasion, reduction of liquidity However this may be the best of available options.

Conclusion The impossible trinity is a fundamental constraint for monetary policy in an economy like India Using monetary policy to manage exchange rates and inflation is ineffective A second policy instrument is required to manage large capital flows. A quantitative measure like a transactions tax which can be adjusted according to circumstances is perhaps the best solution