Automatic stabilisation of the macroeconomy
Business Standard, 16 March 2026
In the last two weeks, the new war in the Middle East has delivered a global economic downturn alongside an oil and gas shock. The transmission of this distress to India operates through four distinct channels:
- A physical gas shortage,
- Elevated oil prices,
- A reduction in inward remittances, and
- A contraction in export demand from the Middle East.
This adds up to an adverse macroeconomic shock for India. How does the economy adjust to this external environment? What forces assist stabilisation? Some kinds of stabilisation require government action. The market economy is resilient: it contains stabilisation that happen for free. These "automatic stabilisers" only require the government to watch from the sidelines.
Rupee depreciation bolsters the economy
The single biggest path to economic adjustment for us, in this global mess, is the depreciation of the exchange rate. A weaker rupee initiates a change in relative prices that helps the economy through four channels:
- It makes imported goods costlier. Faced with higher prices, the people of India will import less.
- The people of India shift their consumption and buy more from Indian firms, which bolsters domestic demand.
- A weaker rupee means Indian exports are more competitive, so foreigners buy more from India.
- For products that are traded at global prices through goods arbitrage, such as steel, the domestic price is made by the global price times the exchange rate. For these firms, an exchange rate depreciation straight away gives gains in the topline.
But then we should ask: Why does the rupee do all these nice things for India at a time when we need it most? Why does the rupee depreciate when faced with all this global distress?
Rupee depreciation is made on the capital account
The key insight runs through capital flows. The magnitude of the gross flows on the capital account are large, and they dominate the financial market equilibrium on the exchange rate. When adverse shocks hit India, global capital flows demand cheaper asset valuations in India. This reassessment of risk generates pressure on the currency market. Investors adjust their portfolios, capital flows respond, and the exchange rate moves downward.
Normally, the gains from capital account openness are seen as pushing down the Indian cost of capital, and bolstering financial system development. What we have here is a third and distinct pathway for gains from capital account openness: As capital flows are procyclical, the open capital account induces exchange rate changes that stabilise.
Thus, in these bad times, we see the whole machinery of the market economy humming. The capital account generates a currency depreciation, and this currency depreciation bolsters firms and jobs and GDP in India.
It's an automatic stabiliser
The elegance of this mechanism is that it requires no movement from the Indian authorities or policy makers. There is no problem of building state capability. There is no problem of policy mistakes. All these good things just happen for free. The only mistakes that can happen are state interference in these natural market processes [link, example, example]. It is quite something to behold, the quiet homeostasis of the price system, the resilience of the price system, through which shocks are continuously absorbed.
Symmetry between good times and bad times
Most of us in India, by now, have understood and appreciate one part of the story. There is a broad consensus that a weaker currency aids the economy during a crisis. But we are less willing to support the mirror image of this process: what happens in good times.
These exact forces work in reverse in good times. In good times, economic freedom gives us a surge in capital flows, which fuels a currency appreciation. The currency appreciation, by altering relative prices in the opposite direction, restrains the firms and the jobs.
Overall, the combination of an open capital account and a flexible exchange rate gives us all this stabilisation for free. It adds up to an automatic stabiliser. In good times, it restrains the irrational exuberance; in bad times, it staves off the doom. Many people in India like to oppose openness on the capital account and the market-determined exchange rate. A better understanding of the valuable contribution these things make, in building macroeconomic stability for India, will help.
Discretionary currency policy destabilises private behaviour
Right now, India is doing badly in the context of the Iran war, and we loudly see the gains from exchange rate depreciation. Consequently, the central bank does not interfere in the market process. But at other times, the central bank interferes with the market process in a discretionary and non-transparent way. This blow-hot-blow-cold induces instability.
The private sector has no idea what will happen when. Discretionary, unpredictable state action destabilises the expectations of the private sector and spoils their decision making. When firms cannot model the exchange rate regime, their choices regarding investment, capacity expansion, and currency hedging are impaired. Further, discretionary actions run into the problems of mistakes and limited state capability. The knowledge required to systematically beat the market and determine the "correct" exchange rate is not available to the state apparatus. It sounds nice to say, Of course, right now, exchange rate depreciation is in India's interests, but we reserve the right to interfere at future dates based on our judgement. But at a deeper level, that is a bad regime to operate.
The impossible trinity
The economists have a grand framework for this landscape: The impossible trinity. This is the idea that no country can have more than two of three features: control of its exchange rate, control of its monetary policy, and the benefits of openness on the capital account. Any two of these are attainable; all three are not. If a central bank attempts to manage the exchange rate while capital flows freely, it loses control over domestic interest rates.
Finding the right corner of the impossible trinity
We in India have locked down one question. We know that we want control of our own monetary policy with an inflation target. Monetary policy -- the short-term interest rate of the economy -- will be only devoted to the pursuit of consumer price index stability at 4 per cent. Inflation targeting in India is now 11 years old, and everyone in India has got this point. We are in the journey of building state capability at RBI to deliver on the promise of a stable 4% inflation rate. This is a quantitative monitorable target where RBI is held accountable and feedback loops will push capabilities forward.
To see the inflation targeting reform through, we need the other two pieces. The government has to step out of activities on the exchange rate, and the government has to step out of interference on the capital account. Viewed as a state capability problem, there is no meaningful path to state capability on knowing how to hinder cross border flows and how to manipulate the currency market in welfare-enhancing ways. Both kinds of interference create contradictions, induce mistakes by firms, induce instability, and hinder Indian economic growth. Embracing the automatic stabiliser of the open economy will give us a long-term, stable, harmonious arrangement that is best suited to foster Indian success.
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