India’s Trilemma: Financial Liberalisation, Exchange Rates and Monetary Policy


  • We are grateful to NIPFP-DEA conference participants and an anonymous referee for helpful comments and suggestions. We thank Yuhan Xue for excellent research assistance.

  • An earlier version of this paper was presented at the 7th NIPFP-DEA Research Meeting held in New Delhi, India, August 31–1 September 2010.


A key challenge for macroeconomic policy in open economies is how to simultaneously manage exchange rates, interest rates and capital account openness – the trilemma. This study calculates a trilemma index for India and investigates its evolution over time. We find that financial integration has increased markedly after the mid-2000s, with corresponding limitations on monetary independence (MI) and exchange rate stability (ES). In addition, we empirically confirm that a rise in one trilemma variable is traded off with a drop in the weighted sum of the other two, i.e. the trilemma configuration is binding in India. Finally, we consider the implications of changes in the trilemma index for macroeconomic outcomes. We find that greater MI systemically contributes to lower inflation, so the twin goals of ES and capital account openness may create policy dilemmas in particular economic environments. ES is associated with less inflation volatility, suggesting that there may be secondary benefits channelled through import and commodity prices. In these relationships, however, changes in international reserves are not statistically significant, suggesting that foreign exchange market intervention has not mitigated the trilemma trade-off in India.