Here is Question No. 61 a part of our series on UPSC Prelims 2022.
Q61. Consider the following statements:
- The tight monetary policy of the US Federal Reserve could lead to capital flight.
- Capital flight may increase the interest cost of firms with existing External Commercial
borrowing (ECBs). - Devaluation of domestic currency decreases the currency risk associated with ECBs.
Which of the statements given above are correct?
a) 1 and 2 only
b) 2 and 3 only
c) 1 and 3 only
d) 1, 2 and 3
Answer – A
- Tight monetary policy implies the Central Bank (or authority in charge of Monetary Policy) is seeking to reduce the demand for money and limit the pace of economic expansion. Central banks engage in tight monetary policy when the economy is accelerating too quickly or inflation is rising too fast and usually involves increasing interest rates.
- Statement 1 is correct: The tight monetary policy of the US Federal Reserve means hiking the federal funds rate–the rate at which banks lend to each other–increases borrowing rates and slows lending. Rate increases make borrowing less attractive as interest payments increase. It affects all types of borrowing including personal loans, mortgages, and interest rates on credit cards. Central Banks enact monetary policy to keep inflation, unemployment, and economic growth stable and positive. When the economy overheats central banks raise interest rates and take other contractionary measures to slow things down – this can discourage investment and depress asset prices. Thus, the tight monetary policy of the US Federal Reserve could lead to capital flight by the investors.
- Statement 2 is correct: The sudden stops and reversal of capital flows will lead to depreciation pressures on emerging market currencies like the rupee. When foreign investors invest in equities, bonds, and other financial assets in EMEs, they measure financial returns in the US dollar and other foreign currencies. Capital flight can drive up interest costs as there is a reduced money supply in the system. Thus, it would lead to an increase in the interest cost of firms that have external commercial borrowings.
- Statement 3 is incorrect: Devaluation of domestic currency does not affect the ExternalCommercial Borrowings as it is denominated in the foreign currency and not in the domestic currency
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