Problem Set

1. A huge amount of liquidity was created by the central banks of developed economies
which started moving into the developing economies like India, China and Vietnam.
This huge liquidity started reviving in the stock markets without the economy actually
reviving and Nifty made a low of 7500before it started to move higher and has
recently touched a level of 13,000. The inflows of foreign currencies were mainly due
to FPI investment in equities (hot money), companies raising cheap money from
outside the country (Trade Finance, FCNR Loans, ECBs), huge NRI inflows
amountingto₹35,000 crore in April-August 2020 (as people employed outside the
country lost their jobs due tothe pandemic and returned to India) and investment of
$25 billion into Reliance Industries. At the same time, the import demand for
petroleum products and gold fell between March and July -2020. With the
government focus on ‘vocal for local’, imports should also come down. In fact, they
have been down in the current financial year till October 2020 by about 35 per cent
while exports are down just 19 per cent. With the Centre giving a push to the ‘Make
in India’ initiative and exports worth $500 billion yearly, it would like the exporters
to be supported/incentivised. A depreciating currency never supports exports because
in this globalised era the foreign importers also demand their pie and the extra cash
flow due to the depreciation does not accrue to the exporters. But it does make the
exports cheap and our products demand increases in the foreign country.
(a) Explain the impact of rise in global liquidity (fall in global interest rate), fall in
import demand for oil by India and fall in import demand for gold by Indians on
USD/INR through appropriate mechanism
(b) If the focus of the Indian Government is on “Make in India” scheme with one of
the objectives being boosting exports, what kind of intervention should RBI be
doing in the forex markets? What should be the expected movement of USD/INR
in the coming months

2. India is being swamped with foreign capital flows along with Covid-19. Initially, it
was Reliance Industries’ breath taking fundraise. Now, in the last two months,
foreigners have bought around $11billion of Indian equities. The RBI under Governor
Das has resisted rupee appreciation. It has been buying up dollars and bulking up the
foreign exchange reserves. The resultant money printing along with other measures
during the pandemic has taken banking system liquidity to an unprecedented surplus.
 The banking system’s ‘core’ liquidity now stands at around Rs 9 lakh crore. Short-
term money market rates (treasury bills, CP, CDs) are below the Reverse Repo Rate
of 3.35%. The policy Repo Rate is at 4%.CPI inflation is at 7.6% and is forecasted to
average above 5% until September 2021. RBI targets CPI at 4% with a threshold band
of 2-6%. The RBI has pledged that it will remain accommodative into the next
financial year. This means they will not increase the interest rates and will continue to
keep the system liquidity in surplus. The Indian capital market is very open. The RBI
cannot use capital controls to control the flows. It does not want the rupee to
appreciate much as it impacts the Atma Nirbharta policy. It does not want to suck out
the liquidity from the markets as it wants to keep rates low to revive growth. If global
excess liquidity finds its way into India, RBI won’t be left with much choice but to
allow the rupee to appreciate. Given the situation discussed above use the Mundell
Fleming Model to explain what policy stance should the country take?
3. Fiscal contraction may not lead to a reduction in output. Comment on this
statement with reasoning.
4. The government has chosen a fixed exchange rate and restricted capital mobility.
The government considers a fiscal expansion. The opposition chooses a monetary
expansion. Which policy group would you choose and why?
5. Interest rates in India on 1 year bonds are 9 percent, while interest rates in US on
one year bonds are 2 percent. Exchange rate is expected to be 65 of India’s
currency per US currency. Current exchange rate is 62. Comment on the following
statements:
(a) Exchange rate for India’s currency should be rising in future
(b) Exchange rate for India’s currency should be falling in future

6. An economy was hit by a severe draught causing massive decline in income and
output. The government received a loan from international advocacy bodies.
Using the loan, the government initiated a host of stimulus packages to improve
the economic health of the country. However, output growth was still sluggish.
Households in the economy were not sensitive to interest rate changes in the past,
and this behavior had continued. The central bank of the economy wanted to
pursue an accommodative monetary policy. However, the government denied this
stance due to vested interest and borrowed money from other economies causing
debt levels to increase. In the meanwhile, the government used the loans received
from international advocacy bodies to help domestic manufacturing and service
companies. Output started to increase. However, this had its own cost and
benefits. What would be the resulting changes in the economy’s fundamental
indicators due to this scenario. As a policy advisor to the government, would you
have alternate suggestions. Explain by applying macroeconomic concepts.