8/13/2019 Whats wrong with Indian economy

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There are basically three main objectives of Indian monetary policy:

1: Growth

2: Price Stability

3: Exchange rate stability

One of the biggest limitations of monetary policy is that it is trying to achieve its objective using one

instrument i.e. targeting interest rate which is not advisable. For each objective different instrument

should be used as steps taken towards one of the objective normally goes against the other objective.

For e.g. if government increase interest rate to target inflation then it may affect the growth and

exchange rate as the firms will find it difficult to take loan and this it will affect the expansion and thus

will slowdown growth. Also increase interest rate can increase cost of the goods and thus making our

exports less competitive which can affect the inflow of foreign currency thus affecting the exchange rate

stability.

Right now what the RBI is finding it most harmful to the economy is Inflation and exchange rate

fluctuation. So right now the monetary policy is trying to control inflation at the expense of growth by

continuously increasing the repo rate. The rationale behind this move of RBI is that once Inflation goes

out of control then it becomes very difficult to control the same. Secondly due to high inflation savings

of people are diverted from saving accounts and financial assets to physical assets as saving accounts

and financial assets are not giving any significant real rate of return due to high inflation.

Since the saving are not coming into financial sector so there is less spending on investment activities

due to lack of capital and which is affecting the growth and development of country.

Since RBI cannot affect the supply side constraint and increase in capacity takes time so in short term itmakes sense to tackle demand which is being done by RBI by increasing the repo rate. The increase in

repo rate has decrease the liquidity in the market thus reducing demand and thus helps in controlling

inflation.

The actions of RBI are also proving a step in right direction in tackling the other problem with the

economy i.e. instability of exchange rate. There are many negatives effects of instable exchange rate

and the free fall of rupees. First of all many Indian firms have loans in foreign currency and the

downslide of rupee has affected them very badly as they now had to pay significantly more towards the

interest payment and principal amount. Secondly it has also reduced the investor confidence in the

country and global investors are unlikely to be lured by 10-year government bonds, even though theirpercent yield is far more attractive than the return on comparable U.S. Treasuries. Investors will bite

only if they can get a positive return after hedging the currency risk rate of which is very high due to

instability in exchange rates. Thirdly since India is a net trade deficit country the depreciation of rupee

will lead to widening of its current account deficit thus having negative effect on both the financial

stability of the country and its image as an investment option.

8/13/2019 Whats wrong with Indian economy

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So RBI is trying hard to tackle the problem of exchange rate instability by implementing a lot of

measures. The increase in repo rate has decrease the liquidity in market which increased the demand

for Rupee leading to its appreciation. RBI has also taken some measures to increase the forex reserves

and prevent depreciation of rupee by making sufficient availability of dollars in the market and also

reducing the demand for the same. This was done by first putting restrictions on the import of gold

which provide significant relief in the demand for dollars. Secondly providing swap window for FCNR

Bond deposit having maturity of 3 years and above at a fixed rate 3.5 % in September have attracted

more than $34 bn which have eased the situation to a great level. Also decrease in demand due to

liquidity crunch has also reduced imports that have reduced the demand for dollars. All these measures

reaped well and brought down the CAD to record low level of $ 5.3bn in July Sept quarter which is just

1.2% of GDP

Thus, right now measures followed by RBI are proving beneficial to the economy to fight back the two

big problems namely Inflation and exchange rate instability.