Journal Press India^®

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The theory of ‘Impossible Trinity’ says that if a country, having a fixed exchange rate and open capital account, tries to have an independent monetary policy (like setting higher interest rates than overseas) then it will be frustrated.            This paper is an attempt to analyse how the Reserve Bank of India (RBI) navigated the trilemma from 2003-04 to 2011-12 when capital flows surged. Firstly, the RBI used extensive capital controls post 2004 to regulate the capital flows. However it is seen in the paper that although there were a lot of de jure controls, de facto these controls were weakened due to increased pace of financial liberalisation. Secondly, the RBI switched from a monetary targeting framework to a 'multiple indicator' approach. Here monetary policy signals were largely transmitted through modulations in policy rates (repo/reverse rates under the daily Liquidity Adjustment Facility). In addition, the RBI used a combination of instruments such as the Cash Reserve Ratio (CRR), open market operations (OMO), Market Stabilization Scheme (MSS) to modulate liquidity in the system. Thirdly our results from the GARCH analysis show that RBI's policy intervention increased volatility. The reason may be that RBI typically intervened in the forex market during times of high volatility and so there was a possibility of RBI's actions adding to the volatility in the market due to uncertainty. 

Keywords

Capital controls, trilemma, exchange rate

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