Question

The Indian authorities recently announced that they would allow foreign investors to buy Indian government bonds denominated in Rupees (INR) in the secondary market (i.e., the market where existing bonds are traded among investors), if these investors hold on to the bonds for a minimum of two years.

Suppose that foreign sovereign wealth funds with massive amounts of dollars to invest decide to purchase substantial quantities of these bonds; at the same time, the Reserve Bank of India (RBI), the Indian central bank, makes it clear that it will NOT intervene in the foreign exchange market.

a. How would this capital inflow affect the dollar value of the Indian Rupee (that is, the exchange rate of $/Rupee) and the real interest rate in India? Show graphically and briefly explain.

(Hint: Start with the foreign exchange market, and then move to the credit market (or “real loanable funds” market. You only need to consider these two markets here.)

b. Will this capital inflow affect India’s monetary base? Its money supply? Explain.

Answer 1