ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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The Reserve Bank of India’s Trilemma Choice

A Tale of Five Governors

The Reserve Bank of India, like most central banks, has to choose between the three corners of the impossible trinity, that is, free capital flows, monetary policy independence and exchange rate stability. This article uses the Aizenman et al (2008) framework to analyse the trilemma choice of the RBI over 2000–22. The results provide interesting insights into the RBI’s shifting position in managing the impossible trinity over the years.

The conduct of monetary policy in India underwent a significant trans­formation during the post-reform period. With the phasing out of automatic monetisation and adoption of fiscal discipline under the Fiscal Responsibility and Budget Management (FRBM) Act, 2003, the Reserve Bank of India (RBI) was relieved from the fiscal dominance of its monetary policy. The financial sector reforms, including greater operational autonomy to the banks, activated different channels of monetary policy transmission. Switching over to “inflation targeting” in 2016 brought further clarity by assigning an explicit legal mandate for hierarchical preference in favour of price stability. Reforms in the external sector also brought a new dimension as regards the conduct of monetary policy, parti­cularly concerning the so-called impossible trinity.

The “impossible trinity” implies that an economy cannot enjoy monetary policy autonomy under a fixed exchange rate regime while allowing for free cross-border capital flows (Mundell 1963; Fleming 1962). If a country allows for liberal international capital flows, then it has to adopt a flexible exchange regime and enjoy independent monetary policy. Or, it needs to sacrifice monetary policy autonomy under a fixed/administered exchange rate regime. By independent monetary policy, it is implied that the central bank enjoys complete flexibility to change the interest rates at home in pursuit of the objective of monetary policy.

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Updated On : 20th Oct, 2023
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