Foreign Exchange Interventions Not a Major Constraint on Monetary Policy Independence: RBI Study

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There is a high degree of absorption of the impact of the money supply resulting from interventions in the foreign exchange market, and no major constraining influence of foreign exchange interventions on the independence of monetary policy, according to the conclusions of an RBI Working Paper.

The article, titled Monetary Policy Independence Under a Flexible Exchange Rate Regime – Assessing the Indian Case, explores whether foreign exchange market interventions by the Reserve Bank of India continue to provide independence monetary policy or encroach on monetary independence.

It poses a macroeconomic challenge to policymakers when monetary policy independence, exchange rate stability and capital account openness cannot be achieved simultaneously.

In the age of international capital mobility, it is argued that monetary policy independence may be limited under a fixed exchange rate regime, even in the short run. However, in a flexible exchange rate regime, monetary policy is effective.

This basic framework is known as the Mundell-Fleming model. The model has earned the popular term “impossible trinity” in which macroeconomic management is questioned because monetary independence, fixed exchange rate and capital account openness are impossible to achieve together.

Economies that do not opt ​​for a fixed exchange rate regime have more control over their domestic monetary policy. While operating with a flexible exchange rate, India intervenes in the foreign exchange market to contain exchange rate volatility resulting from ups and downs in capital flows.

Given that flexible exchange rates are meant to enable monetary independence, the paper seeks to determine whether India’s exchange rate policy – under a flexible exchange rate regime with intervention to contain volatility – has limited the independence of monetary policy. With India’s relatively open capital account, the trilemma comes down to whether the exchange rate is fixed or flexible.

The paper follows a two-step approach to find the impact of foreign exchange market intervention on India’s monetary policy independence for the period from 1991 to 2020.

First, the level of sterilization of excess reserve money resulting from foreign exchange market interventions and its effectiveness in maintaining monetary policy independence are estimated.

Second, the paper estimates whether interventions in the foreign exchange market have an impact on the weighted average overnight money rate, the operational objective of monetary policy in India.

The document indicates that even during periods of intervention in the foreign exchange market by the RBI, inflation has been low and stable in India.

The evidence presented in the paper indicates that the RBI sterilizes or absorbs much of the excess money supply generated by foreign exchange market interventions.

Intervention in the foreign exchange market can be inflationary if excess money supply beyond the absorptive capacity of the economy is not sufficiently sterilized.

The results suggest that there is a high degree of sterilization of the increase in the money supply resulting from the interventions in the foreign exchange market, but the offsetting flows due to the decline in net domestic assets and the hardening of yields do not limit the independence of monetary policy.

The study also finds that moderating global risks lead to increased capital inflows into India. However, the resulting foreign exchange intervention to contain the volatility of the INR and the resulting increase in the money supply is neither inflationary nor does it elicit a reaction from the policy rate.

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