- October 7, 2022
- Posted by: OptimizeIAS Team
- Category: DPN Topics
Context: The trilemma has come under focus recently as the U.S. Federal Reserve has been raising interest rates to fight rising prices. In a world where capital is largely free to move across borders, this has led many investors to pull money out of the rest of the world and rush to the U.S. in search of higher yields, thus putting pressure on many currencies such as the Indian rupee. In fact, even developed markets like Japan and the Eurozone have seen their currencies depreciate significantly against the U.S. dollar.
- The policy trilemma refers to the trade-offs a government faces when deciding international monetary policy. In particular, the policy trilemma contends that it is not possible to have all three objectives at the same time, but has to choose two from the following three options:
- Free movement of capital
- Independent (autonomous) monetary policy
- Fixed (managed) exchange rates
- The Impossible Trilemma, an important paradigm of open economy macroeconomics, asserts that a country may not be able to stabilise the exchange rate, and conduct an independent monetary policy when it is financially integrated with the rest of the world.
- Policymakers in all sophisticated economies face this trilemma, forcing them to make choices about which targets they are going to pursue.
- The RBI has tried to avoid these choices: It has tried to pursue all three objectives simultaneously in an especially aggressive manner since the pandemic struck.
- It has reduced its policy interest rate to negative levels in real terms.
- It has bought government securities to push down long-term interest rates.
- It has allowed large capital inflows, then intervened in the foreign exchange market to prevent the appreciation of the rupee. These actions are incompatible, and will eventually generate a serious policy dilemma.
- One of the corners of the trilemma has to do with capital inflows. In the first few months of the pandemic and the associated lockdown, the Indian economy witnessed a net outflow of foreign portfolio investment (FPI). However, this trend has reversed in recent months.
- At the same time, the combination of weak economic growth, lacklustre domestic demand, and low oil prices have shifted the current account balance from deficit into surplus. Imports have fallen more than exports suggesting that India is doing worse than its trading partners. These factors have changed the balance of supply and demand in the foreign exchange markets as a result of which the currency has begun to face appreciation pressures against the dollar. This brings us to another corner of the trilemma — currency stability.
- Retail inflation has now breached the upper limit of 6 per cent for more than three quarters. Core inflation has been rising and inflation expectations have jumped sharply. And while credit to the private sector remains depressed, credit to the government has been strong, implying that overall broad money is growing rapidly.