Policy Trilemma in India

What is it about?

This paper aims to investigate the situation of policy trilemma in India. Analysing the quarterly data from 1991 to 2015, we find that though the trilemma constraint is binding in the long run, there is ample evidence of short-run deviations from the constraint. Intervention in the foreign exchange market by the Reserve bank of India has successfully helped to relax this constraint. We further examine the determinants and the macroeconomic effects of the trilemma policy configuration. We find that the trilemma efficiency depends on the financial stress, financial development, intervention by the Central bank and the liquidity in the economy. Higher monetary policy independence helps to reduce the inflation rate while exchange rate stability and capital account openness are associated with the growth rate and output gap.

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Why is it important?

Indian economy has systematically moved towards more flexible and market determined exchange rate regime. Due to the high and sustained growth rate, better macroeconomic fundamentals, increased capital mobility, adoption of inflation targeting policy, a more committed monetary policy has made the trilemma issue so pertinent for India. the paper uses the most extensive data set available for India. Our sample consists a longer period in the post global financial crisis which includes several important macroeconomic events at the both local and global front. Second, the paper finds that though the trilemma constraint holds in the long run, but there are several instances of short-run deviations. RBI’s intervention in the foreign exchange market is successful in mitigating the trilemma constraint. Third, we have put a sincere effort to explore the determinants of trilemma efficiency. A large number of studies have focused on the determinants of the each of the three policy goal separately. However, there are only a few papers that have attempted for the joint determination of policy combination.