Interestingly, and unfortunately, only two of the following three could be achieved.
1. Fixed Exchange Rate
2. Independent Monetary Policy
3. Free Flow of Capital
Fixed (or stable) exchange rate has been a top priority for the developing economies like India. Fluctuations in exchange rate, which indicate political instability and other things not conducive to trade, would adversely impact our commerce. To maintain this stability, RBI buys rupees or dollars as per the situation, and needs to keep an adequate amount of forex reserve with itself.
Monetary policy consists of controling the supply of money in market. The excess of liquidity puts inflationary pressure on economy whereas lack of it causes credit crunch, so a healthy balance is needed to promote growth without inflation. RBI adjusts Bank Rate (and repo rate, reverse repo rate etc), CRR* (Cash Reserve Ratio) and buy/sell government bonds to effect monetary expansion and contraction.
Until a few years back, the lack of capital had been the main obstruction in the path to growth. Today it is not like that. People having money don't want to put all their eggs in the same basket whereas people having growth potential are willing to share a part of their profits with moneylenders. Result - boom in financial markets. Foreigners are setting up their industries, acquiring local firms and also buying shares in Indian companies**. The capital account surplus (net sale of financial assets plus debt) finances current account deficit (net import, which also equals the excess of investment over saving).
GDP = C+I+G+NX
=> GDP-C-I-G = NX
=> (GDP-C-G)-I = NX
=> S-I = NX; where S = GDP-(C-G) => Saving equals production minus consumption
Traditionally, we have chosen to be a closed economy and the main concern of RBI was to stabilize inflation and peg our currency at the fixed value. It was hard to achieve these objects in open market, because as per the trilemma, we'd either have to leave the value of currency floating or.. no, the other option was, and still is, absolutely unthinkable for a country where even those millions who live above poverty line live a life of poverty.
By early nineties, the failure of our governments to eradicate poverty, combined by external pressure from international institutions (IMF, World Bank) obliged us to open our markets for all. And the policy trilemma became a reality. Today, when the flood of capital inflow has broken all the walls and foreigners are more than eager to exploit the golden Indian opportunity, our govenment has to decide the cap over capital inflow and the range in which it would allow the exchange rate to float.
In last few months a huge inflow of money has put inflationary pressure on economy. And day before yesterday RBI has increased CRR by 50 basis point and it is speculated that this will drain around Rs 16Cr out of market***. The large demand of Rupee in forex market has resulted in appreciation with respect to dollar (to the dismay of exporters). But RBI has refrained from pumping rupee in forex market till now. That'd stabilize the exchange rate but again the increased liquidity through capital inflow, unless it is prevented by cap, would threaten a price-hike.
*Multiplicity of money is closely linked to CRR ->
Total Money in circulation = (r/(1-r))M; if CRR = 10%, R = 0.1 and TM = 9M!!
**The last example is FII, rest are FDI.
***Also, this step might lead banks to reduce deposit rates and increase lending rates. Lending rate might be left unchanged as they are more dependent on short-term repo rate.
