UPSC Prelims 2022 Question:

Consider the following statements

1. Tight monetary policy of US Federal Reserve could lead to capital flight.
2. Capital flight may increase the interest cost of firms with existing External Commercial Borrowings (ECBs).
3. Devaluation of domestic currency decreases the currency risk associated with ECBs.
   
   

Which of the statements given above are correct?

Explanation: 

• Tight monetary policy is a course of action undertaken by a central bank to slow down overheated economic growth. It aims to constrict spending in an economy that is seen to be accelerating too quickly or to curb inflation when it is rising too fast. When the US Federal Reserve adopts a tight monetary policy, India may see foreign capital flowing out. This is due to higher interest rates offered in the US which could attract investors. So, statement 1 is correct.
  
  

• Capital flight destabilizes interest rates and exchange rates and also reduces monetary control. It drives up the marginal costs of foreign borrowing. Thus, capital flight may increase the interest cost of firms with existing external commercial borrowings. So, statement 2 is correct.
  
  
• The devaluation of currency increases the cost of borrowing of the firms that denominate debt in foreign currency and thus adversely affect the investment and net worth of the firms. Thus, devaluation of domestic currency increases the currency risk associated with External commercial borrowings. So, statement 3 is not correct.
  
  

Therefore, option (1) is the correct answer.