Macro economic effects of changes in selected monetary and fiscal variables for India

Abstract

This paper attempts to build an aggregative, structural, macro-econometric model for India. The model is monetarist in focus and extends the work of Rangarajan and Arif to include the external sector. Annual time series data for the period 1972-2001 are used for this purpose. To overcome the problem of non-stationarity of the variables, the estimated equations are specified in growth-rate form and three-stage least squares method of estimation is used. The model is validated for its in-sample and out-of-sample forecasting ability. A few counter factual simulations are undertaken to illustrate the usefulness of the model for analysing the policy options in a simultaneous equations framework. A sustained increase in RBI credit to commercial sector seems to affect few of the endogenous variables considerably. In the immediate and short run, an increase in RBI credit would lead to increase in reserve money and money supply significantly. This rise in money supply will cause moderate increase in real output and prices. In the external trade sector, exports seem to fall, imports will rise and balance of payments seems to decline. These effects get reversed in medium to long run. The above policy change causes no significant effect on investment variables at any point of time. A reduction in nominal foreign direct investment does not seem to affect most of the endogenous variables significantly, in the immediate and short run. However, there are substantial effects over medium and long run due to such an exogenous sustained change. These changes are driven by decline in foreign exchange reserves and money supply. The fall in money supply results in marginal decline in real output and prices. Further, there are sizable changes in the trade sector. These include rise in real export demand due to fall in unit value of exports and fall in real imports. But, the balance of payments continues to worsen. As another model variant, money supply was made exogenous to compare the results of changes in fiscal and monetary policies, viz., (a) rise in govt. real capital expenditure and (b) increase in money supply. Fiscal policy change seems to increase real output with lesser inflation than the envisaged change in monetary policy. There are no significant changes in investment variables due to increase in money supply. Increase in govt. real capital expenditure seems to cause private corporate investment to rise marginally as a crowding- in effect. Balance of payments seems to improve over time due to increase in real govt. expenditure, where as it deteriorates in the event of increase in money supply.