debt flows and for long term flows over short term flows. but in the real world, we seldom find ourselves in such a sweet spot ; capital flows are either too much or too little. when capital flows are far in excess of cad, the exchange rate appreciates out of line with fundamentals. and if the flows are volatile, that will be reflected in the exchange rate movement too. the reserve bank then has to make a judgment on whether or not to intervene in the forex market. this is not as straight - forward as it seems. if we intervene to buy foreign exchange in the market, volatility may be smoothed and exchange rate bis central bankers ’ speeches appreciation contained, but systemic rupee liquidity goes up, and that could add to inflationary pressures. inflation, as we know, results in a real appreciation of the currency. so, our effort to solve the problem of nominal appreciation of the currency, lands us with a problem of real appreciation. to get around this problem, that is to contain inflationary pressures, we sometimes “ sterilize ” the excess liquidity. this may contain inflation pressures, but raises a host of other problems. sterilization puts upward pressure on interest rates which erodes our competitiveness. higher interest rates also attract more capital flows, thus again, in a curious variant of the dutch disease, accentuating the very problem that we were, in the first place, trying to resolve. as you see, there are no straight - forward solutions – every solution raises a fresh problem. volatile capital outflows pose similarly complex policy choices. in this case, the exchange rate tends to depreciate, again out of line with fundamentals exacerbating inflationary pressures and also hurting the government and corporates who have external debt obligations. in an outflow situation, financing of the current account deficit could also turn into a problem. both when inflows and outflows are out of line with our requirement, the reserve bank has to make a determination on whether or not to intervene in the foreign exchange market to contain volatility and prevent instability. as i explained above, no option is totally benign ; no matter what option we follow, there are costs. our effort always is to make an assessment of the forces driving the capital flows and act only to smooth volatility in the exchange rate movement and prevent disruptions to macroeconomic stability. in doing so, we have to be mindful of the inflation situation,

movements that are inconsistent with inflation converging to the target may undermine the credibility of monetary policy, and we know inflation expectations are critical in the functioning of the regime. to apply a policy that is inconsistent with the inflation target would end up weakening it as the inflation anchor. this is particularly important in the case of emerging economies with a shorter record of monetary stability. another reason that has been put forward to not try to affect asset prices through monetary policy is simply that it is impossible to determine when prices are significantly misaligned with their fundamentals. cecchetti et al. ( 2000 ) point out that asset price misalignment with their equilibrium level is what must be incorporated in the monetary policy rule. however, it is difficult to know with precision the precise level, so it may be impossible to manage the degree of uncertainty. still, i believe it is possible to know when asset prices are fundamentally misaligned in specific episodes. this takes me to the role played by the exchange rate in monetary policy, something as important as or more important than asset prices in emerging economies. an inflation - targeting regime, where the policy instrument is the interest rate, must operate within a context of a flexible exchange rate. this solves efficiently and unambiguously the well - known impossible trinity problem and allows the control of interest rates at a level consistent with the inflationary objective. adding an exchange rate objective weakens the capacity to manage the interest rate and affects the ability to meet the inflation target. this is no hindrance for the exchange rate to generally have a significant effect on monetary policy decisions, if persistent movements of this variable do affect inflation. in this case, the natural result is a leaning against the wind behavior. when the interest rate appreciates substantially, it prompts a fall in inflation, which will result in a reduction in the interest rate with subsequent pressures to depreciate. however, one must recognize that these are not very significant effects because, in a floating regime, the pass - through coefficient from the exchange rate to inflation is limited. it occurs primarily because of the usual transitory nature of exchange rate fluctuations, due to changes in their fundamentals and their relationship with the stage of the cycle. emerging economies may feel tempted, after a long history of crises caused by exchange rate lags, to handle it to keep it depreciated, due to fear of floating ( calvo and reinhart, 2002 ). handling the exchange rate is, apart from