Mains Practice Questions

Introduction:

In recent years, global shocks such as the Russia–Ukraine conflict, supply-chain disruptions after COVID-19, and aggressive monetary tightening by the US Federal Reserve have heightened economic volatility.

• In this context, India’s macroeconomic stability is tested by the need to simultaneously manage inflation, external sector vulnerabilities, and volatile capital flows, involving difficult trade-offs between growth, stability, and policy credibility.

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Policy Trade-offs Impacting Macroeconomic Stability

• Inflation Control vs Growth Support: The RBI’s inflation-targeting framework (4% ± 2%) requires monetary tightening when prices rise, as seen during 2022–24 rate hikes in response to food and fuel inflation (RBI, Monetary Policy Reports).
  • However, higher interest rates increase borrowing costs, potentially slowing investment and consumption, especially MSMEs.
    • Thus, controlling inflation to protect purchasing power often comes at the cost of short-term growth.
• External Sector Stability vs Exchange Rate Flexibility: Global shocks, such as US Fed tightening, lead to capital outflows and rupee depreciation.
  • RBI’s intervention using forex reserves (over USD 640 billion in 2024) helps manage volatility (RBI data) but excessive intervention can erode reserves.
  • Allowing the rupee to depreciate, supports exports but raises imported inflation, especially for oil.
• Capital Flow Management vs Financial Openness: India benefits from capital inflows to finance its current account deficit (CAD), which stood around 1–2% of GDP in recent years.
  • However, volatile portfolio flows can destabilise markets, as seen during taper tantrum-like episodes.
  • Policy trade-off lies between maintaining investor confidence and using macroprudential measures to reduce sudden outflows.
  • Along with this fiscal consolidation is essential to maintain macro stability and investor confidence.Yet, during global slowdowns, expansionary fiscal policy is needed to sustain demand, as seen in the post-pandemic capital expenditure push.
    • This creates a trade-off between debt sustainability and growth support.

Measures to Minimise Global Spillovers on India’s Macroeconomic Stability

• Strengthening Inflation Management: Use fiscal tools (buffer stocking, calibrated import duties on food/fuel) alongside monetary policy to reduce burden on interest rates alone.
  • Improve agricultural supply chains and storage to reduce food inflation volatility.
• Export Basket Diversification: Promote export diversification (goods and services) to reduce dependence on a few markets and commodities.
  • Reduce oil vulnerability through energy diversification, renewables, and strategic petroleum reserves.
• Managing Capital Flow Volatility: Encourage stable long-term capital inflows (FDI, sovereign funds) over volatile portfolio flows.
  • Use macroprudential measures such as counter-cyclical capital buffers and limits on excessive short-term borrowing.
  • Gradual and calibrated capital account liberalisation to avoid sudden reversals.
• Exchange Rate Risk Mitigation: Allow market-determined exchange rate with RBI intervention only to curb excessive volatility, not to defend fixed levels.
  • Deepen domestic currency derivatives and hedging markets to protect firms from external shocks
• Fiscal and Institutional Coordination:Maintain a credible medium-term fiscal consolidation path while protecting growth-enhancing capital expenditure.
  • Strengthen data transparency and communication to anchor investor expectations.
• Promote Rupee Internationalisation: Expand the use of the Indian rupee in cross-border trade settlement, bilateral swap arrangements, and invoicing of energy and commodity imports.
  • This would reduce dependence on hard currencies like the US dollar, lower exchange rate pass-through to inflation, and enhance India’s resilience to global financial spillovers.

Conclusion:

In a globally uncertain economic environment, India cannot avoid external spillovers but can manage them through resilience and policy prudence. A calibrated mix of inflation control, external sector buffers, and capital flow management, supported by strong institutions and clear policy communication will be crucial to sustaining macroeconomic stability while preserving growth momentum.