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

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. India’s 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 interrelationships. 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-wide’ empirical models, has been a significant area of research in India since the early 1950s 1. 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

In fact the first macroeconometric model was estimated by Narasimahan in 1948 under the guidance of Tinbergen (Krishnamurty, 1992)

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 low2. 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 India’s 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.

Ichimura and Matsumoto (1993) provide a comprehensive account of the macro econometric models of the Asian-Pacific countries. Indian researchers have participated in the Project LINK, where models of numerous economies around the world are modelled.


econometric models and the Computable General Equilibrium (CGE) models. The Ministry of Finance supported the macro economic modelling activity at NCAER during the 1980s and also in the 1990s. Krishnamurty (2001). there is no official RBI macro model for India. 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 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. At the institutional or ‘official’ level. In the case of finance and the monetary authorities. 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. A documentation is provided by Dahiya (1982). the other two official agencies where the need for model based research inputs is more obvious. the ‘environment’ for research on Tinbergen-Klein type macroeconometric modelling may have turned more encouraging in the new policy regime. 3 . maintained and used for policy applications over the years. the Central bank (Reserve Bank of India) and the Ministry of Finance. Surprisingly. the ‘plans’ also determined the scope of fiscal and monetary policies. the initiatives to develop macroeconomic models were either indirect or intermittent5. theoretical underpinnings and time horizon over which the future view of the economy is provided. In this sense. Besides the models of plan variety.II. 5 Although a there are a number of macro models developed by RBI staffers over the years. The ‘plan’ models aimed to provide estimates of investment requirements to meet the targeted economic growth rates. namely. the need was greater for ‘forecasts’ rather than policy evaluation as the ‘plan’ priorities were greater than the other policies. India has had a rich record of research experience with macroeconometric modelling. Alternative Approaches to Modelling of Indian Economy The empirical models of the Indian economy can be broadly classified into three categories: plan models. 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. in his recent review of the macro modelling in India. the most important distinguishing feature is the objective of the model. 4 We do not provide any discussion of the plan models for India in this paper. commercial interest in forecasts of the macro environment is more recent. While the models are distinguished by estimation methods. In the case of Planning Commission. it is only the ‘plan models’ that were developed. notes that.

under Krishnamurty’s classification. With better availability of data. the others ignore the macroeconomic framework and focus on more detailed specification of sectors. Consistent data series were available for only a few years. have followed the policy evolution as well as development of data and estimation techniques. 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. The distinction is in the more detailed coverage of the instruments of policy rather than more detailed management of the economy. 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. including the models of the 1990s. starting from the early 1950s and that too for only a limited number of variables. are those estimated in the 1990s and they begin to reflect the new policy environment. better estimation techniques and greater focus on policy. these models were relatively more detailed than the earlier models. which Krishnamurty terms as belonging to the third generation. Marwah (1991) notes that until the end of 1980s. agents and processes. One set of CGE models is macroeconomic by focus. 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 for the Indian economy. Macroeconometric modelling has evolved in India largely in the academic arena supported directly or indirectly by the official agencies. 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. are those that clearly capture the new policy regime where the prices are market determined. monetary policy and productivity in industry received greater attention. The second half of the 1980s and the 1990s saw more active interest in macroeconometric model building. The first generation models were the early models of the 1960s and 1970s. about 40 macroeconometric models were estimated for the Indian economy. divides the modelling effort. thus. Krishnamurty (2001) tracing the evolution of these models. The fourth generation models. which were estimated under severe data constraints. The fifth generation models. 4 . The global macro models are not developed in the Indian context. Issues relating to trade. The developments in macro modelling in India. The micro CGE models have successfully incorporated detailed ‘global’ environment as compared to the macroeconomic models. almost all of them being the works of individual researchers. into five broad categories as those from the first generation to the fifth generation.

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. Economic Reforms and New Issues for Macroeconomic Modelling The year 1991 was a watershed in India’s economic policies. we present here briefly some trends in the Indian economy up to the beginning of the 1990s. industrial policies. In this sense. 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. 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. While the growth was achieved. 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. deficits and debt and deregulation and growth.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. The trend in fiscal deficit is also illustrated by the 5 . fiscal 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 focus of the changes was to give the markets and the private sector a greater role in the allocation of economy’s resources and reduce the administrative controls on the economy. monetary policies and the international trade policies. The changed policy environment also posed a number of issues to the macroeconomic modelers. 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. The year saw a beginning of major reforms in the area of foreign exchange transactions. there were growing imbalances in the economy. First we point to the acceleration in the rate of economic growth during the three decades since the 1950s. The increase was steady and sustained indicating a policy of rising government expenditures without a simultaneous improvement in revenues. 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. The policy changes were brought about swiftly without the empirical basis for predicting a particular type of response.

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. The policy changes. The other imbalance in the economy is reflected in the rising level of current account deficit relative to GDP. interest payments and support to unprofitable public sector enterprises took larger share of government revenues (Figure 4). improvement in external balances and at the same time sustain the growth momentum. Discretionary restrictions on some of the exports were also relaxed. The actual rates are determined in the market. Industry was no longer required to get ‘licenses’ to set up new production capacities for the vast majority of sectors. The domestic indirect taxes were gradually rationalized by reducing the number of rates and the level of average rate of tax. the rupee/ US dollar exchange rate showed only relatively fewer changes till 1991-92 but since then. India’s exports showed no signs of improvement. government’s ability to provide resources for development were under stress as the bill for subsidies. The Reserve Bank of India now provides only indicative rates to the market. The regime of controls on the inflow of external capital was also relaxed. As noted earlier. The external vulnerability was greater because.rise in the level of public debt relative to GDP (Figure 2). The internal vulnerability was higher because. acceleration in growth was leading to greater vulnerability of the economy to internal and external shocks. The tax rate on corporate and personal income was decreased. trade regime was liberalized: tariff and non-tariff barriers were reduced by lowering custom duties and eliminating other restrictions on imports. The industrial polices saw radical changes. While the deficit increased. were meant to address these issues: reduction in fiscal deficit. The changes implied greater competition from imports. 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. forex reserves decreased by 1990-01 (Figure 3). As Figure 6 shows. the changes are continuous and gradual. while the imports rose steadily (Figure 5). 6 . therefore. Thus. The fiscal reforms meant first a check on expenditures and then restructuring of the tax regime. Foreign investment in the economy was permitted with assurances on the repatriation of profits and capital. The areas that were once the exclusive domain of the public sector were now open to private investors. 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%. particularly in the case of agricultural produce.

the interest rate at which the government would borrow from the market. sectors in which market clearing was achieved by prices. the planning process. Capital markets were also freed from pricing controls. therefore. The relatively greater variation in interest rates is illustrated in the case of the Prime Lending Rate (PLR) of a major investment funding agency. foreign collaborations. Industrial Development Bank of India (IDBI) in Figure 7. For instance. 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. These policies were a combination of monetary policy reforms and the reforms in the banking sector. these changes in policies also had an impact on the inflation rate. The financial sector saw the entry of new investment enterprises. In the more liberal policy regime of the 1990s a number of changes have emerged changing the basic principles under which the economy functioned. led to different pricing regimes in different sectors. The ‘capital’ was valued and ‘priced’ by the market rather than by the government agencies. which the banks were required to keep in the form of statutory reserves. In Figure 8. 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. we have presented the pattern of inflation rate in the Indian economy for the period 1980-81 to 2000-01. The government had access to cheap financial resources of the banking sector. emphasized the special features of the period. the manner in which the rates of interest on bank loans to the investors are determined. They also led to the predominance of the public sector in a number of sectors. The economy had. changes in the product lines. The general thrust of these policy changes was to provide greater role for the markets in the allocation of financial resources. Finally. choice of imported machinery were all essentially now the decisions that the entrepreneurs could make freely without the initial approvals needed on administrative basis. the changes related to the financing of the government’s fiscal deficit. Initially. 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.Increasing the scale of operations. which visualized a particular growth path and composition of growth. The macro models of the ‘planning era’. and sectors in which market clearing was achieved by quantity adjustments and rationing. Changes in the monetary policy were also significant. 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. 7 .

and (g) consumption and saving behaviour are likely to change even more slowly. 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. 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. households. those segments of the models dealing with (a) capital formation. we will consider the changes that have taken place in specific type of interrelationships.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. and (c) external markets are most likely to undergo major changes quickly. Pricing in the manufacturing sector is influenced by the international prices which act as a ceiling. government. IV. the central bank and rest of the 8 . rather than look at complete specification of any particular model. As the purpose of this paper is to focus on the changes in the macro models in response to the changed policy environment. (d) price formation and inflation. 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. a brief overview of the macro-modelling framework is useful. Pandit (1995) in a review of the conceptual framework for the macroeconometric models for India notes that. interest rate and exchange rate. The structure may also be interpreted in terms of the agents in the economy (firms. Economic Reforms and Changes in Model Specification Before proceeding to the particular relationships of the macro models. The key features of the models are given by their structure or ‘closure rules’. Interest rate also is increasingly determined by the market forces 3. and the mark up is now residual rather than a fixed rate 5. and (e) monetary and fiscal linkages and responses are likely to change more slowly and (f) sectoral productivity and overall output. (b) financial and capital markets. 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.

To highlight this point. The services provided by the government are subject to different forces that determine their output levels than the ones supplied by the private sector. sectors and transactions is determined by the objectives of the model. government services and the other services. the output and price adjustment mechanisms that have determined the level of desegregation of the production sectors. manufacturing. It is. In the same manner. The level of desegregation of the economy with respect to agents. In fact. Higher imports result from higher domestic prices and higher GDP but these imports affect prices. macro models have incorporated a separate treatment of the services provided by the government from those provided by the private sector. In the case of manufacturing. sold and consumed. In the case of agriculture and infrastructure. therefore. The prices are influenced by ‘administered’ or ‘government-determined’ prices. sectors (agriculture. Its dominance by the public sector enterprises makes the sector unique in its response to demand conditions and pricing rules. one can also point to the unique nature of the infrastructure sector in the Indian economy. availability of data and the critical distinction between the sub-categories in each of these cases. output is supply-constrained for different reasons. imports and exports) and the processes by which goods and services are produced. The output determination is ‘eclectic’ and neither strictly Keynesian nor classical. Hence. The impact of international price movements as well as that of exchange rate is passed on to the domestic prices. 9 . taxes. Patnaik (1995) points out that agriculture has always received a distinct attention in understanding India’s macro economy. investment. Most macro models of the macro economy in India have followed five-sector classification of production: agriculture. 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 infrastructure. The clusure rules indicate what are the ‘endogenous’ and ‘exogenous’ variables’. services). industry. output is often modelled in terms of a production relationship but. the supply is not ‘upward sloping’. The impact of trade flows on prices is weak and indirect: export growth may influence prices through their impact on money supply. transactions (consumption expenditures. again through their impact on money supply. we have summarized the key mechanisms of output and price adjustments followed in traditionally in Indian macro models in Table 1. subsidies.

administered energy prices. we have summarized the general approach to modelling capital formation in the macroeconometric models for India. also capital stock. The specification of capital formation reflects the structural characteristics of the ‘mixed economy’. The specification also reflects the ‘credit-constrained’ nature of private investment. raw materials influenced by demand pressures (domestic/ imported). neo-classical factors such as real interest rate and taxes also find a role. Beyond this. import prices also play a role. The desegregation into sectors and institutions is common. and partly demand determined Administered Cost of living index.Table 1. reflected by the ratio of money infrastructure supply to real GDP. fertilizer price. The relationship between private and public investment is treated as an empirical issue with aspects of both ‘crowding-in’ and ‘crowding-out’. prices. which is a phenomenon of the 1990s. Traditional Specification of Output and Price Adjustments in the Macroeconometric Models for India Sector Output adjustment Price adjustment Agriculture Supply determined. Infrastructure Services Supply constrained Partly supply constrained (government services). The specification does not reflect the influence of foreign capital flows or foreign direct investment. 10 . ratio of money supply to real GDP In Table 2. supply a Market clearing but also function of natural factors influenced by government – (rainfall) as well as policy determined or ‘administered’ factors (public investment. Public investment is exogenous in ‘nominal’ value but endogenous in real value: inflation may erode the value of public investment in real terms. governmentdetermined purchase price of output) Manufacturing Supply constrained based on Cost plus approach.

Table 2. nontariff barriers on imports. Thus. Some of the impact was lost in the form of higher inflation rate. institutional credit. tax rates. The invisibles account also was frequently exogenous as the capital account. We finally review the specification of the monetary and fiscal relationships in the macro models of Indian economy. 11 . High-powered money is a function of monetized deficit of the Central government and changes in foreign exchange reserves of the Central bank. exports are often modeled as ‘demand’ equations. besides the direct ‘crowding-in’ effect if expenditures were in infrastructure sectors. In an economy subject to severe policy constraints in terms of high import tariffs. Again. stiff export quotas. expansionary fiscal stance of the government did not automatically translate into pure ‘Keynesian’ multiplier effect. institutional credit. household savings Private savings. which in turn had several channels of transmission of the shocks to other variables in the economy. However. agricultural GDP. Money supply is modeled as a function of reserve or ‘high powered’ money. sometimes dependent on institutional credit Manufacturing Infrastructure Services Not significant Exogenous in nominal value Exogenous The major features of the external accounts are noted in Table 3. in some macro models. such eclectic characterization was generally acceptable. invisibles flows were specified as demand relationships. Higher money supply also had a ‘supply side’ effect: bank credit expansion followed the increase in money supply and led to higher investment. However. exchange rate remained ‘exogenous’. Although India has a miniscule share in world trade even today. Traditional Specification of Capital Formation in the Macroeconometric Models for India Sector Agriculture Public sector Exogenous in nominal value Private sector Determined by public sector investment. public investment in infrastructure Not significant Residual in nature. 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. terms of trade. Changes in money supply originating from either of these sources affected prices and inflation rate. increased public spending had a ‘crowding-in’ effect through monetary channels also.

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. tariffs Imports invisibles External debt. 12 . Some of the more recent models have attempted to incorporate these features. unless of course interest rates were altered by policy. GDP. the new features relate to the modelling of exchange rate. interest rate. The increased competition may be captured in terms of a price formation equation: Pd = WP * (1+ tar) * (1+ dt)* er ----------------. IVa. in some cases supply constraints Exports invisibles Exchange rate (nominal).Table 3. export UVI/ world prices.(1) Where. The impact variations in global interest rates had no impact on interest rates in the Indian economy. IV. The macroeconomic models of the pre-1990s vintage. In the final subsection here we also briefly note the implications of data availability to the macro modelling research. 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. did not incorporate the features that emerged during the 1990s. Traditional Specification of External Accounts in the Macroeconometric Models for India Item Relationship Exports (merchandise) World economic activity level. therefore. World GDP Imports Petroleum-related GDP Imports other merchandise Ratio of UVI to domestic price. 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. opening up of the economy to freer trade and investment flows. Export UVI/domestic prices. As noted previously. These attempts are reviewed below.

(2) where. IVb. The world prices have a far greater influence on domestic prices. id = domestic interest rate (say. the above specification does not where trade is not a significant part of total transactions as in the case of services. construction and services. consumer goods. the influence of ‘administered’ prices and the ‘cost-plus’ approach is retained. non-tariff barriers on consumer goods were lowered only as late as in the years 2000 and 2001.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. In the case of agriculture. the lending rate) iw = interest rate in the global capital markets E(∆% er) = expected percentage change in exchange rate θ = a measure of risk associated with the performance of the economy 13 . 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). fertilizers and POL. The ‘cost plus’ approach now gets transformed into one where the cost plus is a ‘residual’. Clearly. and (2) machinery. Even in merchandise trade. which states a direct relationship between domestic and international interest rates: id = iw + E(∆% er) + θ --------------. Therefore. Modelling Interest Rate The Open-economy models of the economy adopt some version of the ‘uncovered interest parity’ approach.

Vasudevan and Sharma. captured in the Edwards-Khan approach: id = λ * io + (1 . One attempt at modelling Indian financial markets at NCAER (Patnaik. capital flows take place to bring the two interest rates on par again. 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 λ = 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. PLR = a0 + a1 BR + a2 PLR (-1) + a3 BCG -------------. 1999).(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 14 .λ) * ic ------------. We note below the approach to modeling interest rates taken in another recent macro econometric model for India (IEG_DSE. 2000) has adopted the approach more common in developing economies.If there is interest rate differential that can not be explained by the expected variations in foreign exchange rate or the risk factors.(4) WRGS = b0 + b1 BR + b2 (DEF/GDPMP) + b3 WRGS(-1) ------------. The strict form of the equation (2) above is not applicable to Indian conditions as yet.(3) where. The relationships noted below are only an approximation of the actual estimates.

we do not discuss it here specifically7. an exchange rate can be found that balances the current account. 1993). 15 . which again is only one alternative to the elasticity approach: 7 The monetary approach leads to the formulation: ∆% er = (∆% M .∆% Y*) + λ ((id – iw). IVc.DEF = fiscal deficit of the Central government GDPMP = gross domestic product at market prices ai’s and bi’s are positive coefficients The specification does endogenize the interest rates but do not capture the role of global capital markets. We note below the ‘purchasing power parity’ (PPP) approach (also called relative PPP approach). The role of central bank interventions in the foreign exchange markets as well as the influence of capital flows is completely exogenous. This formulation can be seen in Rivera-Batiz and Rivera-Batiz. Modelling Exchange Rate The three common approaches to modelling exchange rate are the ‘elasticity approach’ that focuses on the current account transactions. where M is the money supply. 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. The export equations for merchandise trade and invisibles earnings provide the estimated supply of foreign exchange for a given rate of exchange. Y is the level output. 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). 1994). 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 import equations provide the estimate of demand for foreign exchange for current account transactions at a given rate of exchange. Such an approach is implicit in the short-term model developed at NCAER (Bhide and Pohit. Again. As the monetary approach in a sense links both the exchange rate and interest rate determination. The elasticity approach essentially solves for the equilibrium in the market for foreign exchange in the ‘current account’ taking capital flows as exogenous. the superscript ‘*’ indicates foreign market and all other symbols are as explained previously.∆% M*) + θ (∆% Y . given the limited opening up of the economy in the financial markets. the specification will also continue to evolve. Therefore.

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 ---------.∆% Pw ---------------. 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. the exchange rate changes are determined. 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.(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 ai’s are positive and the lags are indicated by the negative numbers within parentheses following a variable. The equation for endogenously determined exchange rate in another recent 16 . The limitations of exogenous capital account or interventions by the government or the central bank in many ways persist. However.∆% er = ∆% Pd . the approach provides an alternative to the elasticity approach. The specification allows for simultaneous determination of domestic inflation rate (from the rest of the macro model) and the exchange rate (equation 6).(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 strict form of PPP is unlikely to hold for a partially open economy such as India’s.

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. IVd. Data Issues 17 . Capturing the Impact of Removing Non-tariff barriers. The approach provides for a framework through which regional level details can be incorporated in a macroeconomic model. 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. A CGE approach (Chadha et al. 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. IVe. 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 reallocation of resources. They also model one component of capital inflow. the approach would seem to have potential for extension to the other sectors as well. While the model presently desegregates only the agricultural sector. Again. 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. as relative prices change. 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. 2000). a CGE approach that captures the impact of trade liberalization on intersectoral 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 foreign direct investment. The model simulates the impact by an implicit reduction in ‘tariff equivalent’ of the non-tariff barrier.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.

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. however. However. The econometric approaches or even the structuralist CGE approaches have tended to be used for forecasting as well and hence. As we noted earlier. The CGE approach provides an alternative where reliance is not on time-series data alone. financial markets as well as fiscal policies are the experience of the Indian economy in the 1990s. The experience may also be useful for modellers of the other economies. the CGE approach has provided only the ‘comparative static’ type of simulations. The review shows that while analytical models of open economies exist. 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. Pandit (1995) suggests that it is realistic to continue to provide estimates of the coefficients. typically the case in the macroeconometric models. V. In other words.The empirical modelling approach is evolving to address the issues raised by the recent policy changes. based on traditional techniques of estimation as the changes are gradual and their impact is also expected to be gradual. The analytical framework will have to be modified to capture such specific features. 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. becomes difficult for the period of the new policy regime as the data available is only a few observations under the new regime. Similar experiences are shared by the other economies in the developing world. domestic markets. In the case of financial markets this approach holds greater potential than in the other markets or sectors. The review has also brought out the issue of data constraints in modelling the transition phase of the economy. an important issue relating to availability of data for the period of the ‘new policy regime’. their actual application will require that the features peculiar to a specific economy are not overlooked. There is. improvement in estimates of the coefficients of the model equations is important. particularly those who are switching from ‘plan model’ to ‘market model’. Liberalization of the trade flows. econometric estimation of the relationships based on time series data. References 18 . The estimation results are subject to the criticism that the estimated coefficients are likely to be less ‘robust’.

Dutt. Econometric Models of Asian-Pacific Countries. Delhi. stern. Ann Arbor. Pohit (1993). and S. Delhi. Themes in Economics: Macroeconomics. and R. Institute of Economic Growth. Oxford University Press. Development Planning Centre. September 2000. New Delhi.N. Aggarwal (2000). IEG-DSE Research Team (1999). S. Bangkok. P. Springer-Verlag. B. V. Krishnamurty. Inter-India Publications. Vol 15. Studies in International Economics. Econometric Modelling and Forecasting in Asia. Open-Economy Macroeconomic Themes for India.. 19 . Economic and Social Commission for Asia and Pacific. Sharma. S. United Nations. R. July 1999. K. Pohit. Development Planning Models. 2. pp. S. Matsumoto (1993). 25 (3).V. in Patnaik. Bhide. Ichimura. Volumes I and II. (1995).P. Forecasting and Policy Analysis through a CGE model for India. Mimeographed. Dahiya.9. Oslo. Krishna. New York. (1982). and M.M.B.Bhattacharya. Pandit. Paper Presented at the Fall Meetings of the LINK Project. K. Bhide. S. (1998). No. Margin. Policies for Stability and Growth: Experiments with a Comprehensive Structural Model for India. A. Aril-June. Revised Version..S. The University of Michigan Press..L. A Macro-Econometric Model for Planning and Policy Analysis in India. Vol. Chadha. and K.A.B. March 2000. K. pp. 25-109. Deardorff. Kalirajan (2000). and Y. in Development Papers No.D. Incorporating Regional Details in a Macroeconometric Model for India: An Application of the Production Frontier Approach. The Impact of Trade and Domestic Policy Reforms in India. Journal of Quantitative Economics. and P. A CGE Modeling Approach. (1989) Macroeconomic Modelling in India: A Selective Review of Recent Research. (Editor). 271-92.

and R. New Jersey. Prentice-Hall. Sharma (2000). Inc. K. Modelling of Financial Sector: Exchange Rate and Interest Rates in the Indian Economy. Klein.. Administrative Staff College. Macroeconometric Modelling of South East Asia: the Case of India. A History of Macroeconomic Model Building. Themes in Economics: Macroeconomics. K. (2001). Delhi. International Finance and Open Economy Macroeconomics. Marwah. Present and Prospects. in Patnaik. UK. mimeo. (editors). Facts and Fancies. I. P. Mimeo. Rivera-Batiz.G. Rivera-Batiz (1994).Krishnamurty. Patnaik. V. Introduction: Some Indian Themes in Macroeconomics.A. Delhi. Hyderabad. Presidential Address. D. F. R. in and Fancies. and K. Pandit. Oxford University Press. (1995). Krishnamurty. Macroeconomic Character of the Indian Economy: Theories. in Patnaik. (1995). (Editor). Edward Elgar. 37th Annual Conference of The Indian Econometric Society. Themes in Economics: Macroeconomics. National Council of Applied Economic Research. K. Marwah. (Editor). in Bodkin. Institute of Economic Growth. Macroeconometric Models for India: Past.B. L. 20 . P. (1991). Vasudevan. Patnaik. and L. Status of Macroeconometric Modelling in India. (1992). New Delhi. P. Oxford University Press. Delhi.L.

0 1980s 1990s 1971-75 1975-80 1980-85 1985-90 1990-95 -1.0 5.0 1.0 1995-00 1970s Figure 2.Fig 1.0 0.0 4. Internal Vulnerability: Fiscal Imbalances (% of GDP) 60 50 40 30 20 10 1980-81 1982-83 1984-85 1986-87 1988-89 1992-93 1994-95 1998-99 1990-91 1996-97 0 2000-01(BE) @ 9 8 7 6 5 4 3 2 1 0 Intdebt(L) GFD/GDPMP (R) Totdebt(L) Extdebt (R) 21 . Acceleration in Per capita GDP in 1980s and 1990s AVerage annual growth rate % 6.0 3.0 2.

Current Account Balance (% of GDP) and Forex Reserves/ Imports 1 1 Forex/imports 1 0 0 0 0 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2 1 0 -1 -2 -3 -4 CAB % GDP Rs/US$ (L) Forex/Imports (R) F 4.Figure 3. T e F ig h isca P l roble : D clinin S re o m e g ha f C apital E pe iture in the C ntral B dg t x nd e u e 100% 80% 60% 40% 20% 0% 1970- 1972- 1974- 1976- 1978- 1980- 1982- 1984- 1986- 1990- 1992- 1988- 1994- 1996- 1998- R v e pe e x nditure C pita e pe a l x nditure 2000- 22 .

rim e d g a f B e a 20 18 16 14 12 10 8 6 4 2 0 R fo s e rm 1970 1972 1978 1980 1982 1984 1986 1988 1992 1994 F u 8 P licy C a g s a d th In tio ig re .Figure 5. o h n e n e fla n R te (% a ) 1 6 1 4 1 2 1 0 8 6 4 2 0 C risis a d re rm n fo s 1996 1974 1976 1990 23 . Trade as % of G P D 12 10 8 6 4 2 1970 1976 1978 1986 1988 1994 1996 1972 1974 1980 1982 1984 1990 1992 1998 1998 1998 BOP crisis/ reform s 0 Exports Im ports F u 6 T e R / U $ R te In re se ig re . h e S a : c a d V ria ility a b 5 0 4 0 3 0 2 0 1 0 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 0 R fo s e rm F 7 P e L n in R te o ID I: %p r ye r ig .

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