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INTRODUCTION
Ô The RBI pursues a policy called a managed float.
Ô The rupee is flexible within limits but the RBI
will intervene to prevent ´excessiveµ fluctuations
Ô At the same the RBI seems to keep inflation low

Ô This creates a fundamental conflict in an

economy with open capital flows which is often
described as the impossible trinity
ÕANAGED FLOAT
Ô An exchange rate which is flexible but where the central
bank intervenes occasionally is called a ´managed floatµ
Ô Reasons for central bank intervention:
a) smoothing excessive fluctuations in exchange rates
b) Exchange rates affect trade and aggregate demand
Ô 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
Õany 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)
Ô The REER is a measure for whether a currency is
undervalued or overvalued. The RBI has used it as guide to
exchange rate management.
Ô Effective means that instead of looking at a single
exchange rate, a composite is created of the exchange rates
of various important trading partners
Ô NEER or nominal effective exchange rate is a composite of
different exchange rates of a country·s various trading
partners.
Ô 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.
Ô REER= NEER *(P(d)/P(f))
Where P(d) is domestic price level and P(f) is foreign price
level

Ô 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
Ô The RBI calculates a 36 country index which
covers around 75% of India·s trade.
Ô The base year is1993-94 and the index uses
three-year moving average trade statistics to
assign weights to the different currencies.
Ô There are two sets of weights: one based on
trade and one based on exports.
Ô In general the RBI has intervened in the
market to keep the REER between 95 and 105.
NEER AND REER INDIA FROÕ 93-94

Source:RBI
IÕPOSSIBLE TRINITY
Ô 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

Closed
Economy

 
 


fixed
exchange
Floating rate

rates system

WHY ÕANAGE EXCHANGE RATES?
Ô Flexible exchange rates too volatile and prone to
overshoot.
Ô Rapidly rising exchange rates can damage export
sector. No social safety net for unorganized
export sector e.g. textiles.
Ô Rapidly falling exchange rates can spark
inflation and damage investor confidence.
WHY OPEN CAPITAL FLOWS?
Ô Capital flows can increase aggregate investment
and raise growth rates
Ô FDI investment brings in new technology and
raises technological progress and growth
Ô Foreign investment can improve institutional
quality of financial markets and increase
liquidity.
WHY INDEPENDENT ÕONETARY
POLICY?
Ô Õonetary policy is the most effective tool for
short-run macroeconomic stabilization
Ô Execution lag is much lower than fiscal policy.

Ô Effective monetary policy helps keep inflation low

and improve investment climate as well as
reduce volatility

Ô Conclusion: All three variables are desirable to

an extent. Solution try to find optimal
combination of 3 variables.
HYPOTHETICAL EXAÕPLE
Ô Think of the three legs of the impossible trinity and give them scores of 1-
10:
Ô Independent monetary policy: 10 being a fully autonomous monetary
policy
Ô Õanaged currency:10 being a fully fixed exchange rate
Ô Capital flows:10 being a fully open capital account.
Ô Then the impossible trinity says that a country can have at most a total
score of around 20.
Ô One way of achieving this is to give one of the three legs completely and
achieve close to full scores on the other two.
Ô Alternatively you can achieve a mix of the three: perhaps around 6 to 7 on
each.
Ô 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 PN·s in 2007 may be viewed as an example of
this.
IÕPOSSIBLE TRINITY IN 2007
Ô In 2007 the RBI seemed to hit the constraints of
the impossible trinity
Ô Huge FII inflows, rising rupee

Ô RBI intervention to prevent rupee from

appreciating
Ô Losing control over inflation because of
overheating economy and high commodity prices
 FOREIGN INVESTÕENT
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Data:RBI
 ÕONETARY GROWTH

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Data: RBI
 RBI FOREX INTERVENTIONS
Data: RBI

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INFLATION RISING AND FALLING
Source: RBI '  
 

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Data: RBI
IÕPOSSIBLE TRINITY IN 2008
Ô At the height of the crisis in late 2008 the RBI
faced the impossible trinity in the opposite
direction.
Ô Huge capital outflows because of crisis led to
downward pressure on the rupee
Ô RBI intervened to prevent rupee depreciation

Ô Such intervention was contractionary in nature

which was inappropriate for domestic monetary
policy
Ô Once again trade-off between exchange rate
management and domestic macroeconomic
management
POSSIBLE SOLUTIONS
Ô Sterilization: combine forex intervention with
offsetting bond transaction.
Ô Problem offsetting transaction may undercut
initial intervention. In general sterilization often
ineffective.
Ô Issuing government bonds and interest payments
impose significant fiscal cost
Ô 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?
Ô Tobin Tax proposed by economist James
Tobin: a tax on short-term currency
transactions in order to reduce exchange rate
volatility
Ô 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
Ô E.g. Brazil recently imposed a 2% tax on
portfolio inflows to restrain capital inflows
and prevent appreciation of its currency.
Ô Possible problems: Evasion, reduction of
liquidity
Ô However this may be the best of available
options.
CONCLUSION
Ô The impossible trinity is a fundamental
constraint for monetary policy in an economy like
India
Ô Using monetary policy to manage exchange rates
and inflation is ineffective
Ô A second policy instrument is required to manage
large capital flows.
Ô A quantitative measure like a transactions tax
which can be adjusted according to circumstances
is perhaps the best solution