India’s trilemma: financial liberalization, exchange rates and monetary policy

Hutchison, Michael and Sengupta, Rajeswari and Singh, Nirvikar (2010): India’s trilemma: financial liberalization, exchange rates and monetary policy.

Abstract

A key challenge for macroeconomic policy in open economies is how to simultaneously manage exchange rates, interest rates and capital account openness—the trilemma. This paper calculates a trilemma index for India and investigates its evolution over time. We find that financial integration has increased markedly after the mid-2000s, with corresponding limitations on monetary independence and exchange rate stability. In addition, we empirically confirm a rise in one trilemma variable is traded-off with a drop in the weighted sum of the other two, i.e. the trilemma configuration is binding in India. Finally, we consider the implications of changes in the trilemma index for macroeconomic outcomes. We find that greater monetary independence systemically contributes to lower inflation, so the twin goals of exchange rate stability and capital account openness may create policy dilemmas in particular economic environments. Exchange rate stability is associated with less inflation volatility, suggesting that there may be secondary benefits channeled through import and commodity prices. In these relationships, however, changes in international reserves are not statistically significant, suggesting that foreign exchange market intervention has not mitigated the trilemma tradeoff in India.

• Item Type: MPRA Paper
• Language: English
• Keywords: Financial trilemma, Indian economy, International reserves, Foreign exchange intervention, Monetary policy, Capital account opening
• Subjects: F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance; F - International Economics > F3 - International Finance; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates

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