A trade off exists between interest rate policy (monetary independence), exchange rate stability (ES) and financial integration. Change in one is necessarily associated with a corresponding change in a combination of the other two components.
Any pair of goals can be achieved by choosing a suitable regime but abdicating third:
1. Free capital flows and exchange stability can happen by adopting a fixed exchange rate but then monetary independence needs to be sacrificed. Home interest rate cannot be then be determined by home country independently and depends upon the foreign interest rate.
2. Free capital flows and independent interest rate requires floating exchange rate. The exchange rate is determined by the market and authorities can determine home country interest rate.
3. The interest-exchange rate stability can be attained by giving up capital market integration.
This trilemma has gained importance as the emerging markets are increasingly entering into world financial markets with goals of exchange rate and macroeconomic stability which has imposed challenges for policymakers. These markets generally operate with partial financial integration and regulate funds through imposing restrictions and managed exchange rate with central bank's intervention in foreign exchange markets.
[...] The Central bank, i.e. RBI has actively engaged in sterilization of these capital inflows and has started to accumulate reserves in the form of foreign exchange. In the following section we have tried to compare different periods starting from 1980s and tried to see how these three factors coexist with each other and which two factors have dominated during different phases of the Indian economy and also plotted along with these three the reserve accumulation by the RBI. The Early 1980s In the early 80's the economy wasn't liberalized and open and hence there was very limited international capital movement and foreign exchange reserve accumulation by the RBI was also limited. [...]
[...] These indices are constructed as follows. Monetary Independence (MI): The extent of monetary independence is computed as the inverse of the annual correlation of the monthly interest rates between the home country (India) and the base country (United States). Here, the base country is defined as the country that a home country's monetary policy is most closely linked within India, the Reserve Bank of India (RBI) uses a number of monetary policy tools like the repo rate, reverse repo rate, reserve ratio etc. [...]
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