Testing the trinity of sovereign monetary policy exchange rate stability and full capital account convertibility in India

Abstract

Under this study, an attempt has been made to test the validity of International Trinity Hypothesis in India. The time series data for the period from 1980 to 2016 has been used. Different time series techniques like Unit root methods, Johansen Cointegration Method, Autoregressive Distributed Lag (ARDL) Model, Structural Vector Autoregressive (SVAR) Model, etc, have been executed. The empirical results confirm the validity of International Trinity Hypothesis in the Indian context. The role of international reserves in the effectiveness of trinity choices has also been analysed. The International Reserves are entered into the trinity framework in two variants. In the first variant, they have converted the trinity triangle into quadrilemma diamond by entering as fourth dimension of trinity newlinehypothesis. Secondly, they are considered as the interaction variable with all the three trinity indices. It is concluded that reserves are playing an important role in making the trinity choices better. In addition, the second variant of quadrilemma analysis has proved that when reserves are being used as an interaction variable with all the three indices then they can invalidate the working of trinity hypothesis in India. The potential determinants of international reserves have also been empirically estimated with the help of structural VAR method and it has been concluded that the Indian reserves accumulation is supporting the precautionary view as against the mercantilist view of reserve hoarding. Moreover, among the precautionary view variables, the variable of Capital Account Openness Index has come out as the most important determinant of international reserves in India. Lastly, the effect of trinity and quadrilemma choices on macroeconomic stability of India has been empirically estimated. The results have proved that the trinity choices are effective in improving the macroeconomic stability of India and especially the combination of CO with MI is best from stability point of view.