FINAL PROJECT

Econ331 : Open Economy Macroeconomics

Abstract
A macroeconomic analysis of India

Jeh Khambata
jkhambata@wesleyan.edu
 1. EXECUTIVE SUMMARY

Through this paper I have analysed India’s macroeconomic situation over the last ten years. I

have collected and compiled macroeconomic data on various indicators like GDP, current

account, financial account, the net international investment position, and numerous more.

India moved to a market-determined exchange rate system in March 1993. Under the new

system, the rupee's exchange rate against other currencies is determined largely by market

demand and supply. The Indian rupee is a floating currency with capital controls.

I modelled the exchange rate system in India and predicted that India will go through a period

of stagflation in the near future if they continue to follow trends without any policy changes. I

have also analysed a hypothetical demand shock that the country is likely to encounter due to

the onset of the new Omicron Covid variant and its consequent lockdowns. In order to tackle

this shock, the policy recommendations would be to increase government spending and cut

taxes which would help the country return to a higher level of output.
 2. DIAGNOSTICS

India is the fifth largest economy in the world and certainly one of the fastest growing

economies in the world.

India’s currency is the Indian Rupee (INR) with 1 INR = 0.013 USD.

India moved to a market-determined exchange rate system during “Liberalization" in March

1993. Under the new system, the rupee's exchange rate against other currencies is set largely

by market demand and supply. The Indian rupee is a floating currency.

Table 1 shows India’s sectoral composition as a percent of Gross Domestic Product, Whereas

Table 2 depicts India’s sectoral composition in slightly more depth.

Table 1
Sector % of GDP
Agriculture 16.38
Industry 29.35
Service 54.27
Total 100
Source: Statistic Times 1

Sectors Of The Indian Economy (%

Of GDP)

Agriculture Industry Service

Source: Statistic Times

1
https://statisticstimes.com/economy/country/india-gdp-sectorwise.php
 Table 2
Sector % of GDP
Agriculture 16.38
Mining and quarrying 2.37
Manufacturing 16.92
Electricity, gas, water supply and other utility sources 2.46
Construction 7.6
Trade, hotels, transport, communication and services related to
broadcasting 17.73
Financial, real estate and professional services 23.07
Public Administration, defence and other services 13.47
Total 100
Source: Statistic Times

Sectors Of The Indian Economy (% Of GDP)

Agriculture
Mining and quarrying
Manufacturing
Electricity, gas, water supply and other utility sources
Construction
Trade, hotels, transport, communication and services related to broadcasting
Financial, real estate and professional services
Public Administration, defense and other services

Source: Statistic Times

India top 5 export and import partners are:

Table 3
Trade Partner Partner Share (%)
United States 16.79
United Arab Emirates 9.14
China 5.35
Hong Kong 11.478
Singapore 10.739

Total 53.497
Source: World Bank2

India’s main Exports3 are:

1. Refined Petroleum

2. Packaged Medicaments

3. Jewellery

4. Rice

5. Cars

India’s main Imports are:

1. Crude Oil

2. Gold

3. Petroleum Gas

4. Diamond

5. Coal briquettes

2
https://wits.worldbank.org/CountrySnapshot/en/IND/textview
3
https://www.worldatlas.com/articles/india-exports-and-imports.html
As of 2019, India’s imports of goods and services as a percentage of GDP is 20.96 %

whereas their exports are 18.43%.

Chart 1
35

30

25

20

15

10

Imports (%GDP) Exports (% of GDP)

Source: World Bank

We can see from the chart above that India generally has more capital inflows than outflows,

hence they are not in an external trade balance. Domestic production is not enough to sustain

the needs of the ever-growing Indian economy with its exponentially rising population.

There has been a definite increase in exports, but a sustained high growth has eluded the

country. India is in a trade balance deficit

India’s top five trade partners constitute more than 50% of its total trade partner share which

is not as diversified as it should be. Considering that India’s main import are crude oil and

petroleum while its highest import is refined petroleum, the price of oil being extremely

volatile does not make their trade very flexible. 4

4
https://www.imf.org/external/pubs/ft/wp/2015/wp15161.pdf
 Table 4

External
Debt (%
OF
Year Trade Balance Reserves (% of GDP) Financing needs GDP)
2010 -4.45 8.43082E-07 -4.449999157 18.513
2011 -6.54 -2.27013E-07 -6.540000227 18.592
2012 -6.73 -2.20107E-07 -6.73000022 21.109
2013 -2.98 5.88589E-07 -2.979999411 23.373
2014 -2.98 1.84313E-06 -2.979998157 23.877
2015 -2.3 2.09478E-06 -2.299997905 23.83
2016 -1.76 6.85867E-07 -1.759999314 23.377
2017 -3.16 1.39811E-06 -3.159998602 19.899
2018 -3.72 -1.39887E-07 -3.72000014 20.134
2019 -2.53 1.94278E-06 -2.529998057 19.759
2020 - 3.95936E-06 - 20.6
Source: World Bank

External debt is the money that a country borrows from a source external to it and must be

repaid in the currency in which it was borrowed. India's external debt came from largely

multilateral institutions. Foreign Direct Investment (FDI) is one of India’s main source of

external financing.

I have calculated India’s “Financing needs” by taking the difference between its Reserves and

the absolute value of Trade balance (exports minus imports).

In the hypothetical situation that all sources of external financing dry up, India would not

have enough reserves to sell in the event of a crisis indicated by the negative figures of

financing needs.

The graph attached below, indicates India’s level of external debt which is increasing over

time. Foreign investors in India would not be able to withdraw their funds immediately as

India has various capital controls in place.

 External Debt (% of GDP)
30

25

20

15

10

0
2008 2010 2012 2014 2016 2018 2020 2022
Source: CEIC data

Employment rate (% of labour force)

52
51
50
49
48
47
46
45
44
43
42
2008 2010 2012 2014 2016 2018 2020 2022
Source: World Bank

As we can observe from the Employment Rate graph above, India is also nowhere close to

being in internal balance as the employment rate has been steadily declining from 2010 with

a sharp decline after 2019.

 Current Account (% of GDP)
2

0
2008 2010 2012 2014 2016 2018 2020 2022
-1

-2

-3

-4

-5

-6
Source: IMF

As India’s Current Account balance has been within 2% within the last 2 years, we can

deduce that it has been in external balance during this period. During 2010- 2013, the country

was not in external balance, but it started to narrow down the gap to a 2% fluctuation limit.

We can also observe from India’s current account balances, India has largely been a net

borrower as its current account balance has been negative with the exception of 2020 where

the balance was positive.

The Reserve Bank of India is India's central bank and regulatory body under the jurisdiction

of Ministry of Finance, Government of India. It is responsible for the supple and issue of the

Indian rupee and the regulation of the Indian banking system.

The objectives of India’s monetary policy, as stated by RBI5, are:

1. Price stability

2. Controlled expansion of bank credit

3. Promotion of fixed investment

4. Restriction of Inventories and stocks

5. Promoting efficiency

6. Reducing rigidity

Inflation is the primary policy target of the Reserve Bank of India, with price stability as “a

necessary precondition to sustainable growth". The RBI considers inflationary pressures as

transient but economists and market participants worry that if inflationary pressures persist,

both central banks would be forced to reverse policy and raise rates. 6

Fiscal policy7, alongside monetary policy, plays a crucial role in managing the country’s

economy. Achieving rapid economic growth is one of the key goals of the Indian

government’s fiscal policy.

The objectives of India’s fiscal policy are:

1. Economic growth

2. Price stability

3. Full employment

5
"Monetary Policy Committee constitution under the Reserve Bank of India Act, 1934 notified".

6
https://www.livemint.com/opinion/online-views/rbi-faces-monetary-policy-dilemmas-11633697715859.html
7
https://www.financialexpress.com/what-is/fiscal-policy-meaning/1771755/
In order to elevate the rate of capital formation both in the public and private sector, fiscal

policy is vital. Fiscal policy helps mobilise considerable amount of resources for financing

numerous projects through taxation as well as minimise the imbalance in wealth and income

distribution.
 3. MODELLING

The Indian rupee is a floating currency with capital controls.

When India decided to be part of the global economy they decided to slowly give up many of

their old socialist policies and “liberalize” the economy in 1991. This was done to increase

efficiency and transparency in order to attract foreign investments. This liberalization

included getting rid of their old fixed exchange rate system in order to help them foster Indian

industry in the wake of their serious economic crisis in 1990.

when INR became a floating currency, India’s current account became fully convertible

whereas the capital account was only partially convertible. This was done to protect the

domestic market from foreign competition. Since, most of the developed countries have fully

convertible capital. 8

8
https://www.indianfolk.com/evolution-indias-exchange-rate-system/
 4. POLICY ANALYSIS

4a. Baseline Model

After analysing the trends from my graphs in the diagnostics section, we can reasonably

expect the current account to increase, GDP could increase at a decreasing rate

The exchange rate would increase very slightly but more or less plateau eventually.

Interest rate is on the decline and inflation is going up along with unemployment

India could enter a period of “stagflation” soon with inflationary pressures increasing and a

stagnant output.

All these factors would probably shift the goods market curve down to the left. Capital

outflows reduce bond demand leading to higher interest rates, which reduces absorption
India, like many global economies, witnessed recession last year in the wake of lockdowns

The central bank restated its accommodative policy stance with liquidity pumping measures

like open market operations and special windows for distressed sectors. Excessive money

printing coupled with emerging inflation can result in stagflation.

The rising threat of stagflation would put the RBI in a dilemma. Easing monetary policy

would in an ideal situation stimulate the economy by stoking demand. But if slow economic

growth is accompanied by price rise, this is a challenge that cannot be tackled by cutting

interest rates, quantitative easing and printing money.

For example, the immediate policy response from the government would be to follow a loose

fiscal or monetary policy to combat falling aggregate output. However, when the economy is

also dealing with rising price levels, a mix of loose monetary and fiscal policy could push

prices upwards even further.

Contrastingly, a tight monetary policy to control inflation would result in higher borrowing

cost, negatively impacting consumption and investment demand. This would decrease the

aggregate output in the economy.

All government expenditure should be directed to help small businesses and the poor

The exchange rate also needs to depreciate to make domestic investments more attractive.

The government should reduce its fiscal deficit and increase interest rates or use quantitative

tightening. As a by-product, growth will initially decline. As the main goal of the RBI’s

monetary policy is to keep price and inflation stable, I would recommend that they use a

contractionary approach to raise taxes and lower government expenditure. This would shift

the asset market curve left and thus lead to both output and prices decreasing. The exchange

rate would also decrease.

4b. Aggregate Demand Shock

The coronavirus pandemic has devastated countries all across the world and had negatively

affected numerous economies. India has been one of the few countries that endured lengthy

lockdowns which disrupted a plethora of small business and ultimately the Indian economy

as a whole. With the emergence of the new Omicron variant, It is likely India will tighten

down once again in order to avoid the disastrous consequences from the first wave of the

coronavirus.

The coronavirus pandemic is a demand shock for the Indian economy and could lead to

further moderation in the country's GDP growth as the coronavirus-induced lockdowns cause

considerable disturbance across multiple sectors.

This sort of shock would shift the asset market curve to the left while the goods market curve

remains unchanged. There’s lower output and a depreciated exchange rate.

Depreciated Exchange rate means interest rate must have decreased by UIP, so there is

crowding in. Decreased income reduces money demand, which decreases interest rates

which in turn leads to capital outflows and hence the exchange rate depreciates.

The lower interest rate and depreciated exchange rate offset some of the effect of the

government spending decrease (crowding in).

In order to tackle this shock, the policy recommendations would be to increase government

spending and cut taxes. This would shift the goods market curve to the right and thus bring

output back up to the optimum level as well as increase the exchange rate.
 5. APPENDIX

Chart 1

3500

3000

2500

2000

1500

1000

500

0
2008 2010 2012 2014 2016 2018 2020 2022

GDP, current prices (Billions of U.S. dollars) GDP per capita, current prices

Source: World Bank

Chart 2

150.00

100.00

50.00

0.00
2008 2010 2012 2014 2016 2018 2020 2022

Nominal Exchange Rate Real Exchange Rate

Source: BIS
 Inflation (annual percent change )
12

10

0
2008 2010 2012 2014 2016 2018 2020 2022

GDP per Financial

GDP, capita, Current Account (
GDP, current prices current current Account (% excludes
Year (Billions of U.S. dollars) Prices prices of GDP) reserves)
- -
2010 1708.46 1.67562E+12 1384.174 3.25348405 69596.55148
- -
2011 1823.052 1.82305E+12 1458.105 3.42928826 59326.09886
- -
2012 1827.637 1.82764E+12 1443.879 5.00488898 85645.68573
- -
2013 1856.721 1.85672E+12 1449.605 2.64566624 59114.89303
- -
2014 2039.127 2.03913E+12 1573.881 1.33950833 68354.00975
- -
2015 2103.588 2.10359E+12 1605.605 1.06754935 67658.96802
- -
2016 2294.118 2.2948E+12 1732.051 0.52788035 29339.93096
-
2017 2651.474 2.65147E+12 1980.694 1.43948892
-76629.5215
- -
2018 2701.112 2.70111E+12 1996.952 2.42860882
60232.61865
-
2019 2870.504 2.8705E+12 2098.933 -1.0368515 86127.81148
-
2020 2660.244 2.62298E+12 1929.677 1.25837087 69767.73076
 6. BIBLIOGRAPHY

https://wits.worldbank.org/CountryProfile/en/Country/IND/StartYear/2015/EndYear/2019/In

dicator/NE-IMP-GNFS-ZS

https://www.livemint.com/opinion/online-views/rbi-faces-monetary-policy-dilemmas-

11633697715859.html

Bank for International Settlements, Real Broad Effective Exchange Rate for India

[RBINBIS], retrieved from FRED, Federal Reserve Bank of St. Louis;

https://fred.stlouisfed.org/series/RBINBIS, December 10, 2021.

https://economictimes.indiatimes.com/news/economy/finance/covid-19-pandemic-severe-

demand-shock-for-indian-economy-db/articleshow/75081249.cms?from=mdr

Rajan R.S., Yanamandra V. (2015) External Financing in India: Sources and Types of
Foreign Direct Investment. In: Managing the Macroeconomy. Palgrave Macmillan,
London. https://doi.org/10.1057/9781137534149_6

https://www.imf.org/external/pubs/ft/wp/2015/wp15161.pdf

https://www.ceicdata.com/en/indicator/india/external-debt--of-nominal-gdp

https://www.financialexpress.com/what-is/fiscal-policy-meaning/1771755/
https://www.indianfolk.com/evolution-indias-exchange-rate-system/