ILA PATNAIK

Since the BOP crisis of 1991 there have been two views of the macro-economics of the Indian economy. One is the standard model of the open economy (widely applied and accepted in the advanced economies) that shows strong trade-offs between a stable exchange rate and monetary independence in the presence of global capital mobility. This is summarised in the “impossible trinity ” namely that a country cannot simultaneously have an open capital account, a fixed exchange rate and monetary policy independence. This paper shows that net capital inflows during 1993-4 and 1994-5 were met by un-sterilised intervention: RBI purchased foreign exchange to keep the nominal exchange rate constant and thus to keep the real rate from appreciating. It concludes that as a consequence reserve money and M3 expanded leading to higher inflation and consequent real exchange rate appreciation. The paper then contrasts this with the second episode of capital inflows starting in April 2002, which was handled by sterilised intervention and reduced monetary growth. Inflation remained low but the gap between Indian and global short-term interest rates widened and the fiscal costs of accumulating reserves rose sharply. An alternative Keynsian model with growth cycles seems more appropriate to some, fo