Explain the economic concept behind each of the following situations a. The depreciation of currency did not lead to an improvement of deficit b. Allowing imports reduces the size of the fiscal multiplier c. RBI intervention in exchange rate determination
India’s preparedness
In May 2013, the Fed indicated the possibility of tapering, (a phenomenon of winding liquidity and reducing money supply which would increase interest rates). Higher interest differential in US caused a panic in Indian stock markets and Bond markets leading to a capital flight. India was in dire straits. The three pressure points that emerged were the unsustainable current account deficit (which had risen to 4.8% of GDP); the possibility of ratings downgrade by international credit rating agencies to junk; and lack of adequate foreign exchange reserves to fight a speculative attack on the rupee. The finance minister vowed to maintain the path of fiscal consolidation and bring down the fiscal deficit to below 5% of GDP. Various cuts in plan and non-plan expenditure have been instituted . It was around the same time that a change of guard was happening in the RBI. The new incoming RBI governor, with the finance minister rolled out several measures to setup a bulwark against these pressure points. RBI instituted several measures to protect the currency. Firstly, Oil and gold were the main factors causing the ballooning deficits. Import duties on gold were hiked, and Petrol prices were decontrolled fully and diesel partially to partially pass on international prices to the domestic consumer, thereby lessening subsidies, and allowing elasticity to play a part in controlling consumption. This led to improvement in CAD. In 2012-13 it stood at 4.8% of GDP but after the measures fell to 1.2% of GDP.
Secondly attempt was made to Shoring up of Forex Reserves. Limits on foreign borrowings were eased for corporate as a start, then, the RBI came out with a program to bring in dollars through the FCNR (Foreign Currency Non- Resident) route. Thirdly attempt was made to curb speculation. RBI squeezed liquidity in the domestic market to prevent easy liquidity from being leveraged to speculate on the forex markets. Short term interest rates were hiked by 300% at the MSF (Marginal Standing Facility). These steps stemmed the outflow of foreign currency, bolstered our own reserves, and instilled some confidence in foreigners on their India investments. The FCNR swap itself brought in 34 billion US Dollars into the country. Due to these measures, and the Fed’s decision to postpone tapering, confidence in India rebounded. FII investments came in, and the rupee rebounded. It seemed markets became too sanguine about having factored in the Fed tapering. The Argentina’s currency crisis exploded and spread the contagion to other countries, the markets became jittery. The Indian rupee, in contrast stood at 62.66 against the dollar. The economic defenses against the
Q.2 Explain the economic concept behind each of the following situations
a. The depreciation of currency did not lead to an improvement of deficit
b. Allowing imports reduces the size of the fiscal multiplier
c. RBI intervention in exchange rate determination
d. near zero interest rates may lead to failure of
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