Understanding Exchange Rate and Reserve Management in India

Abstract

One of the particularly challenging dimensions of macroeconomic management in an open economy is ensuring that the so-called Impossible Trinity or Impossible Trilemma is not consistently violated. This trilemma states that a country has to choose between two of the following three policies: an open capital account, exchange rate stability and monetary policy autonomy (Figure 3.1). Specifically a country can achieve monetary policy autonomy and exchange rate stability by imposing capital controls. On the other hand, a country can operate a completely open capital account and monetary policy autonomy if it lets the currency fluctuate. As countries continue to liberalise their capital accounts and embrace financial globalisation, they need to decide whether they want to move towards more exchange rate stability or monetary policy autonomy. Attempting to control both the exchange rate as well as maintain monetary policy autonomy simultaneously invariably leads to crisis over time (Cavoli and Rajan, 2009).