An Estimated DSGE Model of the Indian Economy.

and interpretation, reflecting monetary policy in an uncertain environment: the more dis-
tant the h-step ahead forecast, the less reliable it becomes, hence the less weight it receives.
In turn, past inflation has a typical Koyck-lag structure. Levine et al. (2007) demonstrate
that a strict inflation forecast based (IFB) Calvo rule is less susceptible to indeterminacy
and has better stabilization properties than conventional IFB rules. These authors show,
in particular, that if such rule is formulated in difference form, the indeterminacy probem
disappears altogether.

Note that we are approximating the behaviour of the central bank with an instrument
rule, rather than assuming that the monetary authority optimizes a specific loss function.
Despite the lack of a substantial body of evidence for the Indian case, the forward-backward-
looking Calvo-type formulation can be useful to analyse the RBI’s interest rate setting
behaviour. Bhattacharya et al. (2010), using VAR methods, find monetary policy in India
to have weak transmission channels. On the other hand, however, Virmani (2004) reports
on the potential forward/backward looking behaviour of the RBI using instrumental rules,
suggesting that a backward-looking rule explains the data well. Our proposal nests both
types of behaviour and can therefore shed light on their relative importance.

2.4 Shock processes

The structural shock processes in log-linearized form are assumed to follow AR(1) processes

log At - log At = pA(log At— ι - log At—1) + tA,t
log Gt - log Gt = pG (log Gt—ι - log Gt-1 ) + eσ,t
log MSt - log MS = Pms (log MSt-1 - log MS)+ tMs,t
log RPSt - log RPS = Prps(log RPSt-1 - log RPS) + tRPs,t

where MS = RPS = 1 in the steady state (so log MS = log RPS = 0), while the driving
shocks ε_i,_t for i = A, G, MS, RPS are assumed to be i.i.d. with zero mean. A₁ and G_t are
balanced-growth paths at a growth rate g with Gt fixed. This completes the specification
of the benchmark NK model.

2.5 Bayesian Estimation for US and India

We now present estimates of the model discussed above for the US and the Indian economies.
This exercise allows us: i) to evaluate how well a baseline New Keynesian DSGE model
fits Indian data, and ii) to highlight some of the distinctive traits between a much studied
developed economy and India. For estimation purposes we linearize about a zero inflation
balanced growth steady state. This is set out for the more general model of section 3 with
financial frictions which reduces to the standard model of this section when the latter are
removed. Next, we briefly describe the estimation methods used in this chapter.

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