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7/29/2019 The Experience of India
1/23
The Experience of India in Using Modelling for
Macroeconomic Policy Analysis
Mr Shashanka Bhide, Chief Economist and Head of Macroeconomic Monitoring and
Forecasting Division, National Council of Applied Economic Research, New Delhi
Summary
Macroeconomic modelling research in India has a long tradition. While the initial application
of economic modelling was motivated by the planning requirements, econometric approach
which focussed more on description of the economy and policy assessment also evolved over
the years. The econometric approach has remained largely in the arena of the academic
efforts at the universities and research institutions. The plan models were developed and
maintained by the official agencies. The CGE approach has also been the effort in the
academic arena.
The policy needs of empirical analysis of the economy have increased with greater
liberalization of the economy. There is also a need for assessment of the economy for
commercial activity. The macro economic models now are looked upon to provide these
research inputs for policies both for the government as well as private sector.
Indias economic policy reforms of the 1990s resulted in wide ranging changes in the way the
markets function. The financial markets including foreign exchange markets as well as the
commodity markets are freed from strict administrative controls. The macro models have
evolved to accommodate these changes in their specification of the economic inter-
relationships.
This paper provides a review of the development of the macro modelling research in India,
major changes in economic policies that began in the early 1990s and finally the manner in
which the macro models have attempted to incorporate the changed economic policy
environment.
I. Introduction
Macroeconomic modelling, defined broadly as development of economy-wideempirical models, has been a significant area of research in India since the early 1950s1.
Besides the empirical models, there have been a number of important contributions by
various researchers to the conceptualization of the Indian economy, which can be termed
theoretical modelling of the economy. For example, Pandit (1999) notes the two basic strands
of classical and Keynesian approaches, which have been debated in the Indian economic
literature. The debate has been on the extent to which the Indian economy fits the key
1
In fact the first macroeconometric model was estimated by Narasimahan in 1948 under the guidance ofTinbergen (Krishnamurty, 1992)
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elements of the two basic paradigms of economic theory. Dutt (1995) provides a review of
the elements of the open-economy modelling framework found in the macroeconomic models
of the Indian economy, in the context of opening up of the economy.
The macro modelling research has followed the evolution of the economy both in
terms of the policy thrust as well as the changing economic structure. For example, while
attention to agriculture and the subsistence nature of production for a majority of the
producers in this sector has continued, greater attention is now paid to the services, trade and
financial infrastructure. Attention has shifted from analysing merely the implications of
government policies on the economy to such factors as private capital flows from abroad.
Thus, macro-modelling research has been responsive to the needs of policy analysis in
India, by providing an empirical framework for addressing the issues such as the implications
of the alternative monetary, fiscal and trade policy measures. The macro modelling research,
particularly that was not part of the planning variety also grew more as a result of work
within the academic circles rather than merely as a policy tool. This feature of research also
enabled the growth of alternative approaches to modelling the economy. The empirical macro
modelling work has kept pace with similar approaches in many other developing economies
although the level of desegregation and use of high frequency data have been relatively low 2.
This paper is an attempt to review the experience of using macro-modelling research
for policy analysis in India. We focus only on the empirical modelling of the Indian
economy.
More specifically, the objective of this paper is three-fold:
(a) To briefly review the alternative approaches to the modelling of the Indian
economy in the more recent period of the 1990s;
(b) To highlight the issues raised by the changes in Indias economic policies of the
1990s and their implications to macro modelling; and
(c) To discuss the changes in the specification necessitated by the policy changes that
have sought to reduce discretionary role of administrative regulation.
Remaining part of the paper is organised in four sections. The alternative approaches
are reviewed in Section II, issues raised by the economic policy changes are discussed in
Section III, changes in the specification of the models required by the policy changes are
noted in Section IV and the Section V provides the concluding remarks.
2
Ichimura and Matsumoto (1993) provide a comprehensive account of the macro econometric models of theAsian-Pacific countries. Indian researchers have participated in the Project LINK, where models of numerouseconomies around the world are modelled.
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II. Alternative Approaches to Modelling of Indian Economy
The empirical models of the Indian economy can be broadly classified into three
categories: plan models, econometric models and the Computable General Equilibrium
(CGE) models. While the models are distinguished by estimation methods, theoretical
underpinnings and time horizon over which the future view of the economy is provided, the
most important distinguishing feature is the objective of the model. The three approaches
reflect varying objectives either in terms of policy analysis or the need for an assessment of
the performance of the economy3.
The plan models aimed to provide estimates of investment requirements to meet the
targeted economic growth rates, the macroeconometric models were essentially meant to
track the evolution of the economy and provide estimates of the impact of alternative policy
scenarios and the more recent CGE models are meant to provide insights into more detailed
workings of the economy4. At the institutional or official level, it is only the plan models
that were developed, maintained and used for policy applications over the years. Surprisingly,
the other two official agencies where the need for model based research inputs is more
obvious, namely, the Central bank (Reserve Bank of India) and the Ministry of Finance, the
initiatives to develop macroeconomic models were either indirect or intermittent5. In the case
of Planning Commission, the need for model-based research inputs may have been greater as
detailed allocation of resources across sectors over time required a rigorous exercise of a
quantitative nature that incorporated not only the physical relationships of production but also
the behavioral relationships such as the consumption pattern of the population. In the case of
finance and the monetary authorities, the need was greater for forecasts rather than policy
evaluation as the plan priorities were greater than the other policies. In this sense, the
plans also determined the scope of fiscal and monetary policies.
Besides the models of plan variety, India has had a rich record of research experience
with macroeconometric modelling. Krishnamurty (2001), in his recent review of the macro
modelling in India, notes that, the environment for research on Tinbergen-Klein type
macroeconometric modelling may have turned more encouraging in the new policy regime.
The key to change appears to be the need for research inputs on fiscal and monetary policies
3 While the policy analysis interest is relatively long standing, commercial interest in forecasts of the macro
environment is more recent.4 We do not provide any discussion of the plan models for India in this paper. A documentation is provided by
Dahiya (1982).5
Although a there are a number of macro models developed by RBI staffers over the years, there is no officialRBI macro model for India. The Ministry of Finance supported the macro economic modelling activity atNCAER during the 1980s and also in the 1990s.
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as instruments of policy rather than more detailed management of the economy. The need for
more accurate macroeconomic forecasts of the economy is also more evident for the business
sector as it is for the policy makers.
Macroeconometric modelling has evolved in India largely in the academic arena
supported directly or indirectly by the official agencies. Marwah (1991) notes that until the
end of 1980s, about 40 macroeconometric models were estimated for the Indian economy,
almost all of them being the works of individual researchers. Krishnamurty (2001) tracing the
evolution of these models, divides the modelling effort, including the models of the 1990s,
into five broad categories as those from the firstgeneration to the fifth generation. The first
generation models were the early models of the 1960s and 1970s, which were estimated
under severe data constraints. Consistent data series were available for only a few years,
starting from the early 1950s and that too for only a limited number of variables. The second
generation models were built in the late 1970s and early 1980s and ventured more into policy
analysis than merely attempting to modelling the economy. With better availability of data,
these models were relatively more detailed than the earlier models. The second half of the
1980s and the 1990s saw more active interest in macroeconometric model building, which
Krishnamurty terms as belonging to the third generation. The distinction is in the more
detailed coverage of the economy, better estimation techniques and greater focus on policy.
Issues relating to trade, monetary policy and productivity in industry received greater
attention.
The fourth generation models, under Krishnamurtys classification, are those
estimated in the 1990s and they begin to reflect the new policy environment. The fifth
generation models, are those that clearly capture the new policy regime where the prices are
market determined, role of public sector is limited to a few sectors and monetary policy
becomes independent of the fiscal stance. The above review does not adequately cover the
modelling efforts along the CGE framework6. One set of CGE models is macroeconomic by
focus, the others ignore the macroeconomic framework and focus on more detailed
specification of sectors, agents and processes. The micro CGE models have successfully
incorporated detailed global environment as compared to the macroeconomic models. The
global macro models are not developed in the Indian context.
The developments in macro modelling in India, thus, have followed the policy
evolution as well as development of data and estimation techniques. The paradigm of the
6 Chadha et al (1998) provide a brief discussion of the CGE models for India in their review of the models forthe Indian economy.
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models has become increasingly complex from one of simple Keynesian system of
expenditure accounting to set of inter relationships that capture the dynamic linkages between
investment and output, deficits and debt and deregulation and growth. Our attempt in this
paper will be to examine the underlying specification of the working of the economy in the
models that were developed prior to the beginning of the new economic policies in the
1990s
III. Economic Reforms and New Issues for Macroeconomic Modelling
The year 1991 was a watershed in Indias economic policies. The balance of payments
crisis of 1991 marked point in history when significant changes in economic policies were
undertaken to tide over the crisis and at the same time to redefine the role of discretionary
economic policy regime. The year saw a beginning of major reforms in the area of foreign
exchange transactions, industrial policies, fiscal policies, monetary policies and the
international trade policies. The focus of the changes was to give the markets and the private
sector a greater role in the allocation of economys resources and reduce the administrative
controls on the economy.
The changes also represented a challenge to the modelers of the economy. The need of
the time was to spell out the implications of the policy changes. The policy changes were
brought about swiftly without the empirical basis for predicting a particular type of response.
In this sense, the policy changes were based on the micro economic reasoning with
considerable evidence on inefficient use of resources under a regime of numerous controls on
the economy. The changed policy environment also posed a number of issues to the
macroeconomic modelers.
In order to understand the type of issues which the policy reforms addressed and the
implications of the reforms to the functioning of the economy, we present here briefly some
trends in the Indian economy up to the beginning of the 1990s. First we point to the
acceleration in the rate of economic growth during the three decades since the 1950s. There
was clearly an acceleration in the rate of growth of per capita GDP during the period of the
1990s (Figure 1). India was indeed one of the top 10 economies in the world in terms the
average rate of growth of GDP in the 1990s. While the growth was achieved, there were
growing imbalances in the economy. The ratio of fiscal deficit of the government to GDP
increased to about 10% by 1990-91 as compared to less than 5% in 1980-81. The increase
was steady and sustained indicating a policy of rising government expenditures without a
simultaneous improvement in revenues. The trend in fiscal deficit is also illustrated by the
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rise in the level of public debt relative to GDP (Figure 2). The other imbalance in the
economy is reflected in the rising level of current account deficit relative to GDP. While the
deficit increased, forex reserves decreased by 1990-01 (Figure 3).
Thus, acceleration in growth was leading to greater vulnerability of the economy to
internal and external shocks. The internal vulnerability was higher because, governments
ability to provide resources for development were under stress as the bill for subsidies,
interest payments and support to unprofitable public sector enterprises took larger share of
government revenues (Figure 4). The external vulnerability was greater because, Indias
exports showed no signs of improvement, while the imports rose steadily (Figure 5).
The policy changes, therefore, were meant to address these issues: reduction in fiscal
deficit, improvement in external balances and at the same time sustain the growth
momentum. The fiscal reforms meant first a check on expenditures and then restructuring of
the tax regime. The changes in the tax regime were related to the overall view of the reforms:
the tariff rate on imports was reduced over the years from the average rate of collection of
about 60% in 1990-91 to the current level of less than 30%. The tax rate on corporate and
personal income was decreased. The domestic indirect taxes were gradually rationalized by
reducing the number of rates and the level of average rate of tax.
Improvement in the external balances was sought through a number of initiatives: the
foreign exchange rate was gradually subjected to the pressures of the market for foreign
exchange for the current account transactions. The Reserve Bank of India now provides only
indicative rates to the market. The actual rates are determined in the market. The impact of
the policy changes in the case of foreign exchange transactions is indicated in the trend
pattern of the exchange rate of the rupee. As Figure 6 shows, the rupee/ US dollar exchange
rate showed only relatively fewer changes till 1991-92 but since then, the changes are
continuous and gradual.
As noted earlier, trade regime was liberalized: tariff and non-tariff barriers were reduced
by lowering custom duties and eliminating other restrictions on imports. Discretionary
restrictions on some of the exports were also relaxed, particularly in the case of agricultural
produce. The regime of controls on the inflow of external capital was also relaxed. Foreign
investment in the economy was permitted with assurances on the repatriation of profits and
capital. The changes implied greater competition from imports.
The industrial polices saw radical changes. Industry was no longer required to get
licenses to set up new production capacities for the vast majority of sectors. The areas that
were once the exclusive domain of the public sector were now open to private investors.
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Increasing the scale of operations, foreign collaborations, changes in the product lines, choice
of imported machinery were all essentially now the decisions that the entrepreneurs could
make freely without the initial approvals needed on administrative basis. Capital markets
were also freed from pricing controls. The capital was valued and priced by the market
rather than by the government agencies. The financial sector saw the entry of new investment
enterprises.
Changes in the monetary policy were also significant. Initially, the changes related to the
financing of the governments fiscal deficit. These policies were a combination of monetary
policy reforms and the reforms in the banking sector. The government had access to cheap
financial resources of the banking sector, which the banks were required to keep in the form
of statutory reserves. These reserve requirements were gradually reduced providing larger
quantum of financial resources in the market: the government was to compete with the other
claimants for these resources. The reforms in the monetary, fiscal and the financial sectors led
to changes in the manner in which the fiscal deficit of the Central government is financed, the
manner in which the rates of interest on bank loans to the investors are determined, the
interest rate at which the government would borrow from the market. The general thrust of
these policy changes was to provide greater role for the markets in the allocation of financial
resources. The relatively greater variation in interest rates is illustrated in the case of the
Prime Lending Rate (PLR) of a major investment funding agency, Industrial Development
Bank of India (IDBI) in Figure 7.
Finally, these changes in policies also had an impact on the inflation rate. In Figure 8, we
have presented the pattern of inflation rate in the Indian economy for the period 1980-81 to
2000-01. The pattern highlights the drop in the rate of inflation in the 1990s after the
initiation of the economic reforms from the high levels seen immediately prior to the reforms.
These wide ranging changes in the policies during the 1990s and the prospects of more
changes now have posed a number of issues for analysis. The macro models of the planning
era, emphasized the special features of the period. For instance, the planning process, which
visualized a particular growth path and composition of growth, led to different pricing
regimes in different sectors. They also led to the predominance of the public sector in a
number of sectors. The economy had, therefore, sectors in which market clearing was
achieved by prices, and sectors in which market clearing was achieved by quantity
adjustments and rationing. In the more liberal policy regime of the 1990s a number of
changes have emerged changing the basic principles under which the economy functioned.
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To illustrate the point we note the following changes as a result of the policy changes of the
1990s:
1. The exchange rate of the rupee can no longer be taken as an exogenous variable in the
macro models which was indeed the case in most cases
2. Interest rate also is increasingly determined by the market forces
3. The monetary authorities use open market operations to influence money supply to a
greater extent than before with the development of a market for government securities
4. Pricing in the manufacturing sector is influenced by the international prices which act as a
ceiling, and the mark up is now residual rather than a fixed rate
5. Private investment is influenced by relative returns across sectors rather than allocations
determined by the government
The major areas where changes have taken place relate to the determination of prices,
interest rate and exchange rate. Pandit (1995) in a review of the conceptual framework for the
macroeconometric models for India notes that, those segments of the models dealing with (a)
capital formation, (b) financial and capital markets, and (c) external markets are most likely
to undergo major changes quickly, (d) price formation and inflation, and (e) monetary and
fiscal linkages and responses are likely to change more slowly and (f) sectoral productivity
and overall output, and (g) consumption and saving behaviour are likely to change even more
slowly. This view appears to be vindicated broadly by the changes in the economy that have
taken place except for the fact that changes in price determination paradigm have been more
rapid than anticipated.
As the purpose of this paper is to focus on the changes in the macro models in
response to the changed policy environment, we will consider the changes that have taken
place in specific type of interrelationships, rather than look at complete specification of any
particular model. We will review the specification followed generally before the new policy
regime was set in motion and the changes the macro models have undergone to reflect such
changes in policy environment.
IV. Economic Reforms and Changes in Model Specification
Before proceeding to the particular relationships of the macro models, a brief
overview of the macro-modelling framework is useful. The key features of the models are
given by their structure or closure rules. The structure may also be interpreted in terms of
the agents in the economy (firms, households, government, the central bank and rest of the
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world), sectors (agriculture, industry, services), transactions (consumption expenditures,
investment, taxes, subsidies, imports and exports) and the processes by which goods and
services are produced, sold and consumed. The clusure rules indicate what are the
endogenous and exogenous variables. The identification of exogenous and
endogenous variables for the model is a function of not only the use to which the model is
put but also the role of economic policies in influencing the markets.
The level of desegregation of the economy with respect to agents, sectors and
transactions is determined by the objectives of the model, availability of data and the critical
distinction between the sub-categories in each of these cases.
Most macro models of the macro economy in India have followed five-sector
classification of production: agriculture, manufacturing, infrastructure, government services
and the other services. In fact, Patnaik (1995) points out that agriculture has always received
a distinct attention in understanding Indias macro economy. In the same manner, one can
also point to the unique nature of the infrastructure sector in the Indian economy. Its
dominance by the public sector enterprises makes the sector unique in its response to demand
conditions and pricing rules. The services provided by the government are subject to different
forces that determine their output levels than the ones supplied by the private sector. Hence,
macro models have incorporated a separate treatment of the services provided by the
government from those provided by the private sector. It is, therefore, the output and price
adjustment mechanisms that have determined the level of desegregation of the production
sectors. To highlight this point, we have summarized the key mechanisms of output and price
adjustments followed in traditionally in Indian macro models in Table 1.
The output determination is eclectic and neither strictly Keynesian nor classical. In
the case of agriculture and infrastructure, output is supply-constrained for different reasons.
In the case of manufacturing, output is often modelled in terms of a production relationship
but, the supply is not upward sloping. The prices are influenced by administered or
government-determined prices. The impact of international price movements as well as that
of exchange rate is passed on to the domestic prices.
The impact of trade flows on prices is weak and indirect: export growth may influence
prices through their impact on money supply. Higher imports result from higher domestic
prices and higher GDP but these imports affect prices, again through their impact on money
supply.
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Table 1. Traditional Specification of Output and Price Adjustments in the Macroeconometric
Models for India
Sector Output adjustment Price adjustment
Agriculture Supply determined; supply a
function of natural factors
(rainfall) as well as policyfactors (public investment,
fertilizer price, government-
determined purchase price of
output)
Market clearing but also
influenced by government
determined or administeredprices.
Manufacturing Supply constrained based on
capital stock, raw materials
(domestic/ imported),
infrastructure
Cost plus approach; also
influenced by demand pressures
reflected by the ratio of money
supply to real GDP; administered
energy prices; import prices also
play a role.
Infrastructure Supply constrained Administered
Services Partly supply constrained
(government services), and
partly demand determined
Cost of living index, ratio of
money supply to real GDP
In Table 2, we have summarized the general approach to modelling capital formation
in the macroeconometric models for India. The specification of capital formation reflects the
structural characteristics of the mixed economy. The desegregation into sectors and
institutions is common. Public investment is exogenous in nominal value but endogenous in
real value: inflation may erode the value of public investment in real terms. The relationship
between private and public investment is treated as an empirical issue with aspects of both
crowding-in and crowding-out. The specification also reflects the credit-constrained
nature of private investment. Beyond this, neo-classical factors such as real interest rate and
taxes also find a role. The specification does not reflect the influence of foreign capital flows
or foreign direct investment, which is a phenomenon of the 1990s.
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Table 2. Traditional Specification of Capital Formation in the Macroeconometric Models for
India
Sector Public sector Private sector
Agriculture Exogenous in nominal value Determined by public sector
investment, terms of trade,institutional credit,
agricultural GDP, household
savings
Manufacturing Not significant Private savings, institutional
credit, tax rates, public
investment in infrastructure
Infrastructure Exogenous in nominal value Not significant
Services Exogenous Residual in nature;
sometimes dependent on
institutional credit
The major features of the external accounts are noted in Table 3. Although India has a
miniscule share in world trade even today, exports are often modeled as demand equations.
But it may also be a fair assessment to say that export equations tend to take the form of
hybrid specification that incorporates both the supply and demand factors. In an economy
subject to severe policy constraints in terms of high import tariffs, stiff export quotas, non-
tariff barriers on imports, such eclectic characterization was generally acceptable. However,
exchange rate remained exogenous. The invisibles account also was frequently exogenous
as the capital account. However, in some macro models, invisibles flows were specified as
demand relationships.
We finally review the specification of the monetary and fiscal relationships in the
macro models of Indian economy. Money supply is modeled as a function of reserve or high
powered money. High-powered money is a function of monetized deficit of the Central
government and changes in foreign exchange reserves of the Central bank. Changes in money
supply originating from either of these sources affected prices and inflation rate, which in
turn had several channels of transmission of the shocks to other variables in the economy.
Thus, expansionary fiscal stance of the government did not automatically translate into pure
Keynesian multiplier effect. Some of the impact was lost in the form of higher inflation
rate. Higher money supply also had a supply side effect: bank credit expansion followed the
increase in money supply and led to higher investment. Again, increased public spending had
a crowding-in effect through monetary channels also, besides the direct crowding-in effectif expenditures were in infrastructure sectors.
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Table 3. Traditional Specification of External Accounts in the Macroeconometric Models for
India
Item Relationship
Exports (merchandise) World economic activity level, export UVI/world prices, Export UVI/domestic prices; in
some cases supply constraints
Exports invisibles Exchange rate (nominal), World GDP
Imports Petroleum-related GDP
Imports other merchandise Ratio of UVI to domestic price, GDP, tariffs
Imports invisibles External debt, GDP
Capital flows Exogenous
Note: Desegregation of trade flows into sectoral level is also followed in a number of macro
econometric models
The fiscal and monetary sector specification generally treated interest rate as an exogenous
variable. The impact variations in global interest rates had no impact on interest rates in the
Indian economy, unless of course interest rates were altered by policy.
The macroeconomic models of the pre-1990s vintage, therefore, did not incorporate
the features that emerged during the 1990s. As noted previously, the new features relate to
the modelling of exchange rate, interest rate, opening up of the economy to freer trade and
investment flows. Some of the more recent models have attempted to incorporate these
features. These attempts are reviewed below.
IV. Response of Macro Modelling Research to the Changed Policy Environment
We have selected some of the main areas where the policy changes have significantly
affected the nature of market mechanism by the changes in the economic policies during the
1990s and how the macro models have and can incorporate these changes. In the final sub-
section here we also briefly note the implications of data availability to the macro modelling
research.
IVa. Modelling Prices and Inflation Rate under a relatively more liberalized trade regime
Reduction in tariff and non-tariff barriers on trade flows results in greater competition in the
market place. The increased competition may be captured in terms of a price formation
equation:
Pd = WP * (1+ tar) * (1+ dt)* er ----------------- (1)Where,
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Pd = domestic price
WP = world price
tar = tariff rate on imports
dt = domestic taxes in the form of countervailing duties
er = exchange rate
The above specification is a major departure from the previous specifications of prices which
were predominantly determined by domestic factors. The cost plus approach now gets
transformed into one where the cost plus is a residual. The world prices have a far greater
influence on domestic prices. Clearly, the above specification does not where trade is not a
significant part of total transactions as in the case of services. Even in merchandise trade,
non-tariff barriers on consumer goods were lowered only as late as in the years 2000 and
2001. Therefore, transformation from the cost plus appraoch to competitive pricing
approach is gradual and the models will continue to incorporate the changes gradually. The
short-term macroeconomic model for the Indian economy maintained at the National Council
of Applied Economic Research (NCAER) in New Delhi has used the specification of
equation (1) above for intermediates other than fertilizers and petroleum products (POL), and
(2) machinery. In the case of agriculture, consumer goods, fertilizers and POL, construction
and services, the influence of administered prices and the cost-plus approach is retained.
IVb. Modelling Interest Rate
The Open-economy models of the economy adopt some version of the uncovered interest
parity approach, which states a direct relationship between domestic and international
interest rates:
id = iw + E(% er) + --------------- (2)
where,
id = domestic interest rate (say, the lending rate)
iw = interest rate in the global capital markets
E(% er) = expected percentage change in exchange rate
= a measure of risk associated with the performance of the economy
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If there is interest rate differential that can not be explained by the expected variations in
foreign exchange rate or the risk factors, capital flows take place to bring the two interest
rates on par again.
The strict form of the equation (2) above is not applicable to Indian conditions as yet. One
attempt at modelling Indian financial markets at NCAER (Patnaik, Vasudevan and Sharma,
2000) has adopted the approach more common in developing economies, captured in the
Edwards-Khan approach:
id = * io + (1 - ) * ic ------------- (3)
where,
io = interest rate in the open economy framework as given in equation (2)
ic= interest rate in the closed economy framework (subject to domestic policies) and
= is the weight (between 0 and 1) depending in the openness of the economy
The specification still requires us to specify the expectations regarding exchange rate
variations which is indicated in the next sub-section.
We note below the approach to modeling interest rates taken in another recent macro
econometric model for India (IEG_DSE, 1999). The relationships noted below are only an
approximation of the actual estimates.
PLR = a0 + a1 BR + a2 PLR (-1) + a3 BCG -------------- (4)
WRGS = b0 + b1 BR + b2 (DEF/GDPMP) + b3 WRGS(-1) ------------- (5)
Where
PLR = prime lending rate of the commercial banks
BR= bank rate charged by the Reserve Bank of India (RBI) on borrowings by the commercial
banks from RBI
BCG = Gross bank credit (total bank credit to the economy)
WRGS = average interest rate on borrowings by the Central government in the financial
market
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DEF = fiscal deficit of the Central government
GDPMP = gross domestic product at market prices
ais and bis are positive coefficients
The specification does endogenize the interest rates but do not capture the role of global
capital markets. Again, given the limited opening up of the economy in the financial markets,
the specification will also continue to evolve. Bhattacharya and Aggarwal (2001) adopt
slightly different specification that included the cash reserve requirement of the commercial
banks rather than the gross bank credit in equation (4).
IVc. Modelling Exchange Rate
The three common approaches to modelling exchange rate are the elasticity
approach that focuses on the current account transactions, the purchasing power parity
approach and the monetary approach that links not only the differences in inflation rates in
the domestic and foreign markets but also the output and monetary policies with the exchange
rate variations. As the monetary approach in a sense links both the exchange rate and interest
rate determination, we do not discuss it here specifically7. The elasticity approach essentially
solves for the equilibrium in the market for foreign exchange in the current account taking
capital flows as exogenous. Such an approach is implicit in the short-term model developed
at NCAER (Bhide and Pohit, 1993). The export equations for merchandise trade and
invisibles earnings provide the estimated supply of foreign exchange for a given rate of
exchange. The import equations provide the estimate of demand for foreign exchange for
current account transactions at a given rate of exchange. Therefore, an exchange rate can be
found that balances the current account.
The above approach does not capture deviations from equilibrium and essentially
does not capture behavioral rigidities in the demand and supply of foreign exchange even in
the current account transactions. The role of central bank interventions in the foreign
exchange markets as well as the influence of capital flows is completely exogenous. We note
below the purchasing power parity (PPP) approach (also called relative PPP approach),
which again is only one alternative to the elasticity approach:
7 The monetary approach leads to the formulation:
% er = (% M - % M*
) + (% Y - % Y*
) + ((id iw), where M is the money supply, Y is the leveloutput, the superscript * indicates foreign market and all other symbols are as explained previously. Thisformulation can be seen in Rivera-Batiz and Rivera-Batiz, 1994).
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% er = % Pd - % Pw ---------------- (6)
Where
% er = percentage change in exchange rate
% Pd = domestic inflation rate
% Pw = Inflation rate in the international economy (major trading partners)
Given the inflation rate in the domestic market and in the international economy, the
exchange rate changes are determined. The specification allows for simultaneous
determination of domestic inflation rate (from the rest of the macro model) and the exchangerate (equation 6). The strict form of PPP is unlikely to hold for a partially open economy such
as Indias. However, the approach provides an alternative to the elasticity approach. The
limitations of exogenous capital account or interventions by the government or the central
bank in many ways persist.
The approach taken in the IEG-DSE model for India is noted below:
er = a0 a1 (CAB/GDPMP) a2 NFE(-1) + a3 er(-1) a4 D8191 ---------- (7)
Where
CAB = current account balance (revenue minus expenditure)
NFE = net foreign exchange assets of the RBI
D8191 = dummy variable distinguishing the pre 1991 period from the subsequent period in
the data
All ais are positive and the lags are indicated by the negative numbers within parentheses
following a variable.
The equation (7) captures the impact of imbalances in the current account as well as the
impact of net capital flows in the previous year. It does at least partly overcome the
limitations noted in the elasticity approach and the PPP approach as it still does not capture
the impact of capital flows in the current year and the interventions of the RBI in the foreign
exchange market. The equation for endogenously determined exchange rate in another recent
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macro model by Bhattacharya and Aggarwal (2000) has similar specification as equation (7)
but for the fact that they look at the foreign exchange receipts and payments separately and
include capital account transactions in defining payments and receipts. They also model one
component of capital inflow, the foreign direct investment.
IVd. Capturing the Impact of Removing Non-tariff barriers, Impact on Income
Distribution and Modelling Regional Variations
The issues raised by the policy changes of the 1990s are varied and despite their
significance can not yet be addressed by the macro models. We merely refer here to some of
the attempts to assess the impact of the economic reforms on some dimensions of the
economy through economy-wide models.
A CGE approach (Chadha et al, 1999) that is set in a global framework has attempted
to assess the impact of reduction in non-tariff barriers on the economy: inter-sectoral re-
allocation of resources, as relative prices change. The model simulates the impact by an
implicit reduction in tariff equivalent of the non-tariff barrier. The economy begins to
export those commodities where India has less of a comparative advantage and shifts
resources to those sectors where the comparative advantage exists.
Again, a CGE approach that captures the impact of trade liberalization on inter-
sectoral allocation of resources and the consequent implications to employment pattern and
household incomes has been attempted to provide an assessment of the impact of selected
policy reforms on income distribution.
The regional variations in output of agriculture as a result of national level policies are
analyzed in the framework of production frontier using a macroeconometric model for India
(Bhide and Kalirajan, 2000). The approach provides for a framework through which regional
level details can be incorporated in a macroeconomic model. While the model presently
desegregates only the agricultural sector, the approach would seem to have potential for
extension to the other sectors as well. Whether some regions in an economy would grow
consistently faster than the others leading to growing sub-regional inequalities in a national
economy is an issue that is concern for the policy makers.
IVe. Data Issues
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The empirical modelling approach is evolving to address the issues raised by the
recent policy changes. There is, however, an important issue relating to availability of data
for the period of the new policy regime. In other words, econometric estimation of the
relationships based on time series data, typically the case in the macroeconometric models,
becomes difficult for the period of the new policy regime as the data available is only a few
observations under the new regime. The estimation results are subject to the criticism that the
estimated coefficients are likely to be less robust. As we noted earlier, Pandit (1995)
suggests that it is realistic to continue to provide estimates of the coefficients, based on
traditional techniques of estimation as the changes are gradual and their impact is also
expected to be gradual. The CGE approach provides an alternative where reliance is not on
time-series data alone. However, the CGE approach has provided only the comparative
static type of simulations. The econometric approaches or even the structuralist CGE
approaches have tended to be used for forecasting as well and hence, improvement in
estimates of the coefficients of the model equations is important.
An additional alternative to the estimation of model parameters that has been explored
is the use of higher frequency data in conjunction with the usual annual data. In the case of
financial markets this approach holds greater potential than in the other markets or sectors.
V. Concluding Remarks
The review of macro modelling approaches in India for the recent period in the
context of the policy changes of the 1990s has implications to attempts at modelling other
economies in transition. Liberalization of the trade flows, domestic markets, financial
markets as well as fiscal policies are the experience of the Indian economy in the 1990s.
Similar experiences are shared by the other economies in the developing world, particularly
those who are switching from plan model to market model. The review shows that while
analytical models of open economies exist, their actual application will require that the
features peculiar to a specific economy are not overlooked. The analytical framework will
have to be modified to capture such specific features. The review has also brought out the
issue of data constraints in modelling the transition phase of the economy. The exploration of
alternative approaches in the Indian case can be expected to continue as the demand for
analyses of the economic trends increases both for public policy as well as decisions in the
business sector. The experience may also be useful for modellers of the other economies.
References
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Bhattacharya, B.B. and M. Aggarwal (2000), A Macro-Econometric Model for Planning and
Policy Analysis in India, Revised Version, Mimeographed, Development Planning Centre,
Institute of Economic Growth, Delhi, March 2000,
Bhide,S. and S. Pohit (1993), Forecasting and Policy Analysis through a CGE model for
India, Margin, Vol. 25 (3), Aril-June, pp. 271-92.
Bhide, S. and K.P. Kalirajan (2000), Incorporating Regional Details in a Macroeconometric
Model for India: An Application of the Production Frontier Approach, Paper Presented at the
Fall Meetings of the LINK Project, Oslo, September 2000.
Chadha, R., Pohit, S., Deardorff, A.V. and R.M. stern, (1998), The Impact of Trade and
Domestic Policy Reforms in India, A CGE Modeling Approach, Studies in International
Economics, The University of Michigan Press, Ann Arbor.
Dahiya, S.B. (1982), Development Planning Models, Volumes I and II, Inter-India
Publications, New Delhi.
Dutt, K.A. (1995), Open-Economy Macroeconomic Themes for India, in Patnaik, P. (Editor),
Themes in Economics: Macroeconomics, Oxford University Press, Delhi.
Ichimura, S. and Y. Matsumoto (1993), Econometric Models of Asian-Pacific Countries,
Springer-Verlag, New York.
IEG-DSE Research Team (1999), Policies for Stability and Growth: Experiments with a
Comprehensive Structural Model for India, Journal of Quantitative Economics, Vol 15, No.
2, July 1999, pp. 25-109.
Krishna, K.L., Krishnamurty, K. Pandit, V.N. and P.D. Sharma, (1989) Macroeconomic
Modelling in India: A Selective Review of Recent Research, in Development Papers No.9,
Econometric Modelling and Forecasting in Asia, Economic and Social Commission for Asia
and Pacific, United Nations, Bangkok.
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Krishnamurty, K. (2001), Macroeconometric Models for India: Past, Present and Prospects,
Presidential Address, 37th Annual Conference of The Indian Econometric Society,
Administrative Staff College, Hyderabad.
Krishnamurty, K. (1992), Status of Macroeconometric Modelling in India, mimeo, Institute
of Economic Growth, Delhi.
Marwah, K. (1991), Macroeconometric Modelling of South East Asia: the Case of India, in
Bodkin, R.G., Klein, L.B. and K. Marwah, (editors), A History of Macroeconomic Model
Building, Edward Elgar, UK.
Pandit, V. (1995), Macroeconomic Character of the Indian Economy: Theories, Facts and
Fancies, in Patnaik, P. (Editor), Themes in Economics: Macroeconomics, Oxford University
Press, Delhi.
Patnaik, I, Vasudevan, D. and R. Sharma (2000), Modelling of Financial Sector: Exchange
Rate and Interest Rates in the Indian Economy, Mimeo, National Council of Applied
Economic Research, New Delhi.
Patnaik, P. (1995), Introduction: Some Indian Themes in Macroeconomics, in and Fancies, in
Patnaik, P. (Editor), Themes in Economics: Macroeconomics, Oxford University Press,
Delhi.
Rivera-Batiz, F.L. and L.A. Rivera-Batiz (1994), International Finance and Open Economy
Macroeconomics, Prentice-Hall, Inc, New Jersey.
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Fig 1. Acceleration in Per capita GDP in 1980s and 1990s
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
6.0
1970s
1980s
1990s
1971-75
1975-80
1980-85
1985-90
1990-95
1995-00
AVerageannualgrowthrate%
Figure 2. Internal Vulnerability: Fiscal
Imbalances (% of GDP)
0
10
20
30
40
50
60
1980-8
1
1982-8
3
1984-8
5
1986-8
7
1988-8
9
1990-9
1
1992-9
3
1994-9
5
1996-9
7
1998-9
9
2000-0
1(BE)@ 0
1
2
3
4
5
6
7
8
9
Intdebt(L) Totdebt(L)
GFD/GDPMP (R) Extdebt (R)
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Figure 3. Current Account Balance (% of GDP) and
Forex Reserves/ Imports
0
0
0
0
0
1
1
1
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Forex/imports
-4
-3
-2
-1
0
1
2
CAB%GDP
Rs/US$ (L) Forex/Imports (R)
Fig 4. The Fiscal Problem: Declining Share of
Capital Expenditure in the Central Budget
0%
20%
40%
60%
80%
100%
1970-
1972-
1974-
1976-
1978-
1980-
1982-
1984-
1986-
1988-
1990-
1992-
1994-
1996-
1998-
2000-
Rev expenditure Capital expenditure
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Figure 5. Trade as % of GDP
0
2
46
8
10
12
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Exports Imports
BOP crisis/ reforms
Figure 6. The Re/ US$ Rate: IncreasedVariability
0
10
20
30
40
50
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Reforms
Fig 7. Prime Lending Rate of IDBI: %per year
024
68
101214161820
1970
1972
1974
1976
1978
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
Reforms
Figure 8. Policy Changes and the Inflation
Rate (%)
0
2
4
6
8
10
12
14
16Crisis and reforms
Recommended