The Experience of India

7/29/2019 The Experience of India

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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

Documents

The Experience of India