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 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
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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 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.
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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.

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
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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 official RBI macro model for India. The Ministry of Finance supported the macro economic modelling activity at NCAER during the 1980s and also in the 1990s.

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 first generation 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
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Chadha et al (1998) provide a brief discussion of the CGE models for India in their review of the models for the Indian economy.

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.

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.

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 Market clearing but also function of natural factors influenced by government (rainfall) as well as policy determined or administered factors (public investment, prices. fertilizer price, governmentdetermined purchase price of output) Manufacturing Supply constrained based on Cost plus approach; also capital stock, raw materials influenced by demand pressures (domestic/ imported), reflected by the ratio of money infrastructure supply to real GDP; administered energy prices; import prices also play a role. Infrastructure Services Supply constrained Partly supply constrained (government services), and partly demand determined Administered 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 Agriculture Public sector Exogenous in nominal value Private sector Determined by public sector investment, terms of trade, institutional credit, agricultural GDP, household savings Private savings, institutional credit, tax rates, public investment in infrastructure Not significant Residual in nature; 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. 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, nontariff 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 effect if 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 subsection 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:

The monetary approach leads to the formulation: % er = (% M - % M*) + (% Y - % Y*) + ((id iw), where M is the money supply, Y is the level output, the superscript * indicates foreign market and all other symbols are as explained previously. This formulation 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 exchange rate (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 reallocation 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 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 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

AVerage annual growth rate % 6.0 5.0 4.0 3.0 2.0 1.0 0.0 1980s 1990s 1971-75 1975-80 1980-85 1985-90 1990-95 -1.0 1995-00 1970s

Figure 2. 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)

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Figure 3. 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. 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-

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Figure 5. 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

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 . 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 . 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

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