An Estimated DSGE Model of the Indian Economy

Abstract

We develop a closed-economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods using Dynare. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, and an informal sector. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward and backward-looking components. We find that, in terms of model posterior probabilities and standard moments criteria, inclusion of the above financial frictions and an informal sector significantly improves the model fit.JEL Classification: E52, E37, E58

An Estimated DSGE Open Economy Model of the Indian Economy with Financial Frictions

“…These results are plausible and are generally similar to those of Gabriel et al (2012). One interesting aspect revealed by these estimates is that prices are estimated to be a lot stickier when financial frictions are absent, while under the second model, firms adjust prices quite frequently, between 1 and 3 quarters, implying only mild price stickiness.…”

“…However, as noted in the introduction, estimated DSGE models for emerging economies, and India in particular, are scarce, though one might infer potential priors by comparing the features and stylized facts of developed and developing economies. In most cases, we use the same priors used in our earlier study (see Gabriel et al 2012).…”

“…Again understanding and modeling the transmission mechanism of the frictions is important for designing policy rules that are robust and can minimize agents' vulnerability to these shocks particularly those arising from international openness. Gabriel et al (2012), in a closed economy setting, show that the introduction of financial frictions in the form of liquidity-constrained consumers and a financial accelerator mechanism are not only realistic, but also conducive to a better empirical performance. Thus, in this paper we develop both closed and open economy DSGE models of India as an emerging small open economy (SOE) interacting with the rest of the world and estimate them by Bayesian Maximum Likelihood methods using Dynare.…”

Technology Shocks and Business Cycles in India

“…We take the subjective discount factor, β equal to 0.98 from Gabriel et al (2010). The capital share, α and the depreciation rate, δ are fixed at the conventional levels 0.3 and 0.1 respectively given the annual frequency of the data.…”

“…The habit persistence parameter, γ c is fixed at 0.6 as in Basu and Thoenissen (2011). The prior for investment adjustment cost parameter is set at 2 as in Christiano et al (2005) and Gabriel et al (2010). Assuming no cross border di §erence in mark up, the steady state price-marginal cost markups for both home and foreign countries are fixed at 1.2 as in Kollmann (2002) Our selection of the probability density functions for the priors are based on the theoretical implications of the relevant parameters in the model and the evidence from extant studies.…”