Inflation targeting and capital flows

  • Blog Post Date 06 January, 2021
  • Perspectives
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Current law in India mandates a review of the target inflation rate by 31 March 2021 for a five-year period. Several critics have called for abandoning the flexible inflation targeting regime altogether. In this post, Gurbachan Singh shows that flexible inflation targeting can accentuate the problem of sudden capital flows, and that the current monetary policy framework can be substantially improved by including two ‘new’ policy instruments that can be used by the Ministry of Finance rather than the RBI.


“… the competition for reputation as “realists” works toward a condition in which students of society are loath to take a minority position. Society tends as a result to lose …” - Clarence Philbrook, 1953.

In 2016, the public authorities in India formally gave the Reserve Bank of India (RBI) the mandate to target an inflation rate of 4% with a leeway of 2% around the target. The RBI is expected to be flexible in its approach, particularly in extraordinary situations. However, what the so-called flexibility means in practice is that the RBI faces a serious trade-off in taking care of ‘other’ objectives such as maintaining full employment, exchange rate stability, financial stability. This is especially the case when we consider India as an economy that is quite open to international capital flows.

In this post, I propose a different macroeconomic policy regime for India as an open economy that goes beyond standard monetary policy and the Keynesian fiscal policy,1 and show how this is superior to the prevailing regime.


Capital flows into and out of India are primarily related to the developed world. Hence, to simplify the discussion, I will consider India and the developed world only. To begin with, I assume that normalcy prevails. This is characterised by some normal inflow of capital. Thereafter, I allow for a downturn or upturn. For simplicity, I assume that this downturn or upturn happens in India only – the developed world remains normal.

A downturn can mean a recession (significant fall in growth rate of GDP (gross domestic product)), or a fall in inflation rate. An upturn can mean an economic boom (significant rise in growth rate of GDP), or a rise in the inflation rate. Recession can be due to a slowdown in the growth process, or a crisis/quasi-crisis. A crisis can be a financial crisis, or a political event such as the nuclear test in May 1998 in India and the subsequent economic sanctions.

For simplicity, it is assumed that we have one interest rate in India and one interest rate in the developed world. The rate of interest is typically higher in India than that in the developed world. In the absence of policy intervention, the interest rate is where the demand and supply curves for funds intersect in a competitive market. It is assumed that in a recession (boom) the demand curve for funds shifts inwards (outwards), while the supply curve remains unchanged. It follows that in a recession (boom) the market equilibrium interest rate goes down (up), relative to normal periods. The new market equilibrium is associated with low investment in a recession and with high investment in a boom. Given this backdrop, we are ready now to consider policy options.

The prevailing policy regime

Often, public authorities are (mistakenly) more responsive to a recession than a boom. However, to maintain simplicity, I will ignore this here. I will also ignore possible issues of exit from policy after a recession. Finally, I also simplify the analysis by ignoring issues of transmission of interest rate policy; the results do not change qualitatively by doing so.

Consider first the case of a recession. As mentioned, the market interest rate goes down due to an inward shift of the demand curve for funds. Now the standard policy response is that the RBI uses its key instrument and lowers the interest rate further to give a boost to aggregate demand. This additional reduction is different. It is not due to a shift in the demand curve; it is a variant of administered pricing. In general, at an administered price that is below the market equilibrium price, we have excess demand. In the more familiar cases of administered pricing in microeconomics, there is a need for rationing, given the excess demand. However, in monetary economics, the variant of administered pricing as applied by the RBI is different. The central bank simply issues more base money, which can be used to meet the excess demand for funds. So, the need for any rationing by the RBI does not arise.

After the inward shift of the demand curve for funds in India, the gap between the interest rate in India and the interest rate in the developed world is less than normal. So, the capital inflow tends to shrink, and it may even become a case of net capital outflow. The tendency for outflow is further accentuated by the RBI when it ‘administers’ an even lower rate of interest. Whether or not real investment is responsive to the rate of interest, capital outflows are. Further, note that the problem of outflows here is partly due to economic conditions and partly due to the RBI policy!

The case of a boom is just the opposite. Whether it is a case of capital outflow in a recession or inflow in a boom, it is not a cause for serious concern for the RBI. This is because besides its key instrument, that is, the interest rate, the RBI has another important instrument (Ghosh et al. 2018): foreign exchange reserves (hereafter, reserves). The RBI has been holding very large reserves for a while now, and it does not hesitate to increase reserves further. This may seem a good idea but the opportunity cost of reserves for the country is very high.

Estimates of the recurring annual opportunity cost of reserves vary between 0.25% and 1% of GDP (Yeyati and Gómez 2019, Rodrik 2006). At 0.5% real interest rate, the capitalised value of the cost is between 50% and 200% of GDP (I am abstracting from economic growth). But even at 2% real interest rate, it lies between 12.5% and 50% of GDP.

Another issue is that in dealing with a downturn (upturn), the RBI policy is the same whether it is a recession (boom) or a fall (rise) in inflation. This may not matter if a recession (boom) is accompanied by a fall (rise) in the inflation rate. However, it matters in case of stagflation2 (as in the 1970s) or if a boom is accompanied by a fall rather than a rise in inflation rate. This aspect will be elaborated on later.

Under the prevailing policy regime, policymakers attempt to stabilise investment – and GDP more generally – over the economic cycle. In the process, due to administered pricing with respect to the interest rate, the rate of growth of base money varies considerably over an economic cycle; it rises in a recession and falls in a boom. This is due to the counter-cyclical monetary policy. More importantly, the interest rate varies substantially over the economic cycle as the RBI tends to lower it in a recession and to raise it in a boom.

The reasons why the large variations in interest rates matter are as follows. First, prices of many assets are inversely related to the interest rate. So, with interest rate changes, asset prices too can vary considerably over the economic cycle as a whole – even if there is little change in fundamentals or sentiment. Indeed, an important reason why many asset prices are currently high lies in the low real interest rates at present. The changes in asset prices can, in turn, affect the real economy (Koo 2018). Second, interest incomes are very low in a recession at a time when the marginal utility of money3 is high.

But what is the alternative? Before we come to the proposed policy regime, note that when the RBI lowers (raises) the interest rate in a recession (boom), it is a quasi-subsidy (tax) for the borrowing entities so that they invest more (less). This simple observation paves the way for an alternative interest rate policy. But the proposed policy regime, as we will see, goes beyond this interest rate policy.

The proposed policy regime

Consider the case where the Ministry of Finance (MoF) – and not the RBI – intervenes to address a recession. It gives a clear subsidy on real investment, to push investment and GDP more generally (Feldstein 2016, Jeanne and Korinek 2010b, Jeanne and Korinek 2019, Singh 2014, Singh 2015, Singh 2020a).

As seen already, the market equilibrium interest rate in a recession is less than that in normal periods. Now due to the MoF subsidy, the demand for funds increases and the interest rate goes back closer to the normal interest rate. Basically, the proposed MoF policy tries to treat the problem at its source and negate the effect of the recession on the demand curve for funds. Normalcy is restored in the sense that both the (post-subsidy) market interest rate and investment are back closer to normal levels.

The initial reduction in the interest rate may lead to capital outflows from the country. However, there is much less of a rationale and incentive for capital outflows after policy intervention, which negates the initial inward shift. This is true, even more strongly, if we include expectations of the policy at the initial stage itself. It is true that after a subsidy on interest cost incurred for real investment, the market interest rate may not go back all the way to the normal rate. If so, there can be some capital outflows. What about these capital outflows?

Some ideas from public economics are applicable to macroeconomics as well. Sudden capital flows can cause negative externalities for the real sector and accordingly there is a need for a Pigouvian tax4 as a corrective measure (Jeanne and Korinek 2010a, Singh 2020b). A tax on such capital flows is effectively a change in the exchange rate that applies only to capital transactions at a time when the capital flows are large and sudden. So, we have here a second well-targeted policy instrument from the MoF.

Given that in a recession, MoF subsidy takes care of the interest rate and investment, and MoF tax takes care of any possible sudden capital outflows and the related volatility in the exchange rate, the RBI can meaningfully focus on targeting inflation. And, it need not hold large reserves.

Inflation targeting has been debatable, if not controversial, ever since it was adopted de-facto in 2013-14 and de-jure in 2016 in India. This is understandable. However, instead of abandoning inflation targeting – as this post has shown – the public authorities should put in place two additional instruments.

Under the tax/subsidy scheme for real investment, we can have a deficit in a recession but a surplus in boom. So, there may be an intertemporal balance in the budget related to the first scheme. Even if it is an intertemporal deficit, the size is likely to be small for obvious reasons. On the other hand, with the second scheme related to sudden capital flows, we have a surplus in both recession and boom. This scheme yields tax revenues and substitutes for the extra reserves.

Let us take an overall view. Given that one MoF scheme can change the effective interest rate for real investment (thus allowing the RBI to target inflation) and the other MoF scheme can take care of capital flows and exchange rate, it follows that broadly speaking it is, in principle, possible to deal with any of the 2x2x2=8 situations: (1) boom, low inflation, and capital inflow (2) boom, low inflation, and capital outflow, and so on, till we reach the eighth situation of recession, high inflation, and capital outflow. This well-targeted approach is not possible under the prevailing policy regime, given the paucity of instruments (Tinbergen 1952). The two MoF schemes can be institutionalised such that Parliamentary approval is not required every now and then (Singh 2020a).

Recall that the interest rate is brought back closer to the normal level in both a recession and a boom under the proposed policy. This implies that the variation in the market interest rate over the economic cycle is minimal for financial investments and for savers; it is somewhat large only for borrowers who make real investments. Accordingly, under the proposed policy regime, given that the market interest rates are close to normal levels, the asset prices are not unstable over the economic cycle as a result of macroeconomic stabilisation policy.

Concluding remarks

The current law in India mandates a review of the target inflation rate on or before 31 March 2021 for a five-year period. Several critics are arguing in favour of abandoning the monetary policy framework altogether. In this post, I show how flexible inflation targeting can accentuate the problem of sudden capital flows. However, we need to be careful in giving policy prescriptions in this regard. We have the experience of high and volatile inflation in the Indian economy in the period prior to 2013-14 – the lessons of dynamic inconsistency in the long-term context, and questionable practical gains in output and employment from higher inflation (Uhlig 2012). Hence, as opposed to abandoning inflation targeting, the way forward should be supplementing inflation targeting by the RBI with two well-targeted instruments that may be utilised by the MoF. These help with stabilising investment, capital flows, and exchange rate in an economical manner.

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  1. Keynesian fiscal policy is about changing aggregate government spending or aggregate taxes for maintaining the aggregate demand for goods and services in the economy over the economic cycle.
  2. Stagflation refers to a situation wherein inflation is high, economic growth is stagnant, and unemployment remains high.
  3. Marginal utility of money refers to the amount by which an individual's utility would be increased if given a small quantity of additional money, per unit of the increase.
  4. A Pigouvian tax is a tax imposed on individuals/businesses for engaging in activities that create adverse side effects for society. Adverse side effects are those costs that are not included as a part of the product's market price.

Further Reading

  • Feldstein, M (2016), ‘The future of fiscal policy’, in O Blanchard et al. (ed.), Progress and Confusion: The State of Macroeconomic Policy.
  • Ghosh, AR, JD Ostry and MS Qureshi (2018), Taming the Tide of Capital Flows – A Policy Guide, The MIT Press, Cambridge, MA.
  • Jeanne, Olivier and Anton Korinek (2010a), “Excessive volatility in capital flows: A Pigouvian taxation approach”, American Economic Review, 100(2): 403-407.
  • Jeanne, O and A Korinek (2010b), ‘Managing credit booms and busts: A Pigouvian taxation approach’, NBER Working Paper No. 16377.
  • Jeanne, Olivier and Anton Korinek (2019), “Managing credit booms and busts: A Pigouvian taxation approach”, Journal of Monetary Economics, 107: 2-17.
  • Koo, R (2018), The Other Half of Macroeconomics and the Fate of Globalization, Wiley, United Kingdom.
  • Philbrook, Clarence (1953), “‘Realism’ in policy espousal”, American Economic Review, 43(5): 846-859.
  • Rodrik, Dani (2006), “The Social Cost of Foreign Exchange Reserves”, International Economic Journal, 20(3): 253-256.
  • Singh, Gurbachan (2014), “Overcoming zero lower bound on interest rate without any inflation or inflationary expectations”, South Asian Journal of Macroeconomics and Public Finance, 3(1): 1-38.
  • Singh, Gurbachan (2015), “Thinking afresh about central bank's interest rate policy”, Journal of Financial Economic Policy, 7(3): 221-232.
  • Singh, G (2020a), ‘Covid-19, and the way to avoid a blunt interest rate policy’, Ideas for India, June 16.
  • Singh, G (2020b), ‘Handling the dollar rush’, Business Standard, August 19.
  • Tinbergen, J (1952), On the Theory of Economic Policy, North-Holland, New York.
  • Uhlig, Harald (2012), “Economics and reality”, Journal of Macroeconomics, 34(1): 29-41.
  • Yeyati, EL and JF Gómez (2019), ‘The Cost of Holding Foreign Exchange Reserves’, Center for International Development Faculty, Working Paper No. 353.
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