What is impossible trinity?
Impossible trinity or trilemma in monetary policy means that a
country cannot have a fixed exchange rate, free movement of capital and an
independent monetary policy at the same time.
- As it happened in India, after lowering
interest rates over the last one year, RBI went ahead to protect the rupee
by sucking liquidity out of the system, which has resulted in higher cost
of money and higher interest rates.
- From a pure monetary policy standpoint, RBI
had no intention of raising interest rates.
- In fact there was a case to cut policy rates
to support growth, but while targeting currency it lost a bit of control
on the monetary policy,which resulted in higher interest rates.
- Suppose, a country that has a fixed exchange
rate raises interest rates to curb in inflation.
- Higher interest rates will attract foreign
capital.
- Since the country has a fixed exchange rate,
the central bank will have to buy foreign exchange to maintain the peg ( matlab ki 'Domestic currency' ki value 'Dollar' k maqable adjust karna) which will lead to injection of domestic currency in the market.
- The rise in availability of money in the
market will bring down its cost (read interest rate) and defeat the
central bank’s idea of curbing inflation (isliye 'Onion' .etc k bhaav asmaan chu rahe hai ) by raising interest rates.
- This is why a lot of countries also have
capital control in place which allows them to maintain stable currency and
have more authority on the monetary policy.
Although the rupee is not pegged to any currency, India does not
allow free movement on the capital account.
Capital control in developing
countries is put in place to preserve financial stability as large inflow and
outflows in relatively smaller markets can lead to financial instability.
The
RBI is not defending the rupee by selling foreign currency in the market, but
if it did, the impact on interest rate would have been the same. Selling
foreign exchange would reduced the supply of rupee in the market which would
have resulted in higher rates.