How has India managed the impossible trinity over the years?

Michael Hutchison, Rajeswari Sengupta and Nirvikar Singh have written this amazing paper (see the ppt for a quicker understanding).

They develop an impossible trinity index for India and see how it has moved/changed over the years. Impossible Trinity means one cannot manage exchange rates, price stability and capital account openness together. One has to give up one of the objectives and there is a trade-off. Read this superb paper from Joshua Aizenamann to understand the trade-offs. Also my two attempts to explain the idea from an Asian and Indian perspective.

Coming back to the paper. So what the authors do is track these trilemma variables over a period of time. In sum, the authors measure tradeoff between financial integration, exchange rate stability and monetary independence in India.

The hypothesis is as India has opened up over the years, one should see either loss of monetary independence or loss of exchange rate stability. And this indeed is the case.

The sample period of the study is q1 1996 to q3 2009. It builds a trilemma index using subindices of all three – financial integration, exchange rate stability and monetary independence.

Analysis is further divided into three-time periods. The results show:


Q1 1996-97 to Q2 2000-01

Q3 2000-01 to Q4 2004-05

Q1 2005-06 to Q2 2009-10

Mon Indep




Exchange Rate Stab




Capital Account Openness








  • As we can see total contribution has hardly changed. Hence there are trade-offs. Something is being given up for something else
  • As capital account openness has increased, we see in phase II monetary indep has been completely lost. exchange rate stability remains a priority
  • In phase III, we see some exchange rate stability being sacrificed for restoring monetary independence.
  • Overall in phase III, we see lower monetary independence and higher capital account openness compared to Phase I.

Great insights. Helps understand the trade-offs much better. Though am surprised by this loss of monetary independence. I would have expected exchange rate stability to be lower than the empirical results. May be when we extend the analysis to cover 2010 period, we see some difference as RBI has hardly intervened in forex markets 2010.

The authors extend this analysis to impact on inflation and inflation volatility:

  • Exchange rate stability appears to dampen inflation volatility: the coefficient is always negative. Increased capital account openness seems to be weakly associated with higher inflation volatility
  • Increased financial integration does not appear to increase the level of inflation –coefficients are mostly negative. Monetary independence does not seem to matter for the level of inflation

Again surprising results esp. monetary independence and level of inflation. It could be that inflation is also dependent on supply side constraints.

What about reserve accumulation and sterilization? Does it help manage the trinity?

We also investigate the role played by international reserves in mitigating the severity of the trilemma faced by India, given that India is now one of the biggest hoarders of foreign exchange reserves. We find that indeed India has been able to actively manage the exchange rate and limit exchange rate volatility relative to other emerging market economies, by building up international reserves and intervening actively in the foreign exchange market. Such reserve management has also helped to some extent in regaining control over monetary policy even in the face of capital inflows.

Finally, we examine the impact of changes in reserve stock and sterilization efforts by the RBI, on the conduct of Indian monetary policy in context of the trilemma. We find that most of the increase in reserves during our sample period was offset by concomitant declines in net domestic assets, thereby suggesting that as a consequence of relaxation of capital controls, the Indian economy did partially lose monetary policy independence. However this issue warrants more detailed empirical investigation and is left as a future extension of this research.

Hmm. Must read paper.


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