The monetary policy committee in the recently held meeting decided to keep the interest rates unchanged. Many economists have expressed apprehension that the RBI is facing the classical macroeconomic trilemma. This article attempts to simplify this economic jargon.
The macroeconomic trilemma is the result of Mundell Fleming model which states that an independent monetary policy, a flexible capital account, and a fixed exchange rate is not possible simultaneously.
The commercial banks are entangled with excess liquidity as a result of demonetization. The RBI attempted to mop out the excess liquidity through its open market operations. However, it decided to suspend its open market sale on November even when the Moody’s revised its ratings. This attributes to the macroeconomic trilemma being faced.
The government yields had crossed 7 %. Had the RBI continued with its open market sales it would have increased the yields further. (Note that yield and price of bonds are inversely related to each other. The higher is the yield, riskier is the security.)
The increased yield would have invited capital flows and appreciated the rupee.
The economy is already mired with rupee appreciation. To avoid further appreciation, RBI might then have to undertake open market purchases of security, thus reversing the initial independent monetary policy of open market sales.
Though India has a partially convertible capital account and managed exchange rate, the application of Mundell Fleming model is still phenomenal.
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