An Estimated DSGE Model of the Indian Economy.

θ larger than 1.5), but less so to inflationary pressures associated with past inflation, as
captured by φ. However, both θ and φ are estimated imprecisely, the latter not being
statistically significant. The degree of forward (backward) Iookingness measured by φ (τ)
is close to the prior value of 0.5, corresponding to 1 quarter.

Estimation of the shock processes delivers interesting results. First, the shocks appear
to be persistent, but less so than for the US. Secondly, the estimated standard deviations
are larger than the US, in accordance with the macro volatility stylized facts typically
associated with emerging economies. Most strikingly, the standard error associated with
the government spending shock reaches a value above 7, while the risk premium shock
standard deviation is also high. The remaining standard deviations are somewhat below
the specified priors.

Overall, the estimated baseline model reveals some useful insights: it correctly predicts
that the Indian economy is subject to more volatile shocks, prices appear to be more flexible
for India than for the in US and that aggressive expected inflation targeting seems to be
consistent with the behaviour of the monetary authorities. In the next two sections, we
investigate further refinements and assess their empirical validity, providing a more thorough
comparison of the different specifications under study.

3 A NK Model with Financial Frictions

We now introduce two financial frictions: liquidity constrained ‘rule of thumb’ consumers
and a financial accelerator for firms. The inclusion of these features is particularly relevant,
not only because it acknowledges powerful transmission mechanisms of shocks in emerging
economies, but it also helps to conceptualize and understand events such as the 2008 global
financial crisis and subsequent economic slowdown. Carlstrom and Fuerst (1997), Bernanke
et al. (1999) and Gertler et al. (2003), for example, stress the importance of financial
frictions in the amplification of both real and nominal shocks to the economy, namely in
the form of the financial accelerator, linking the cost of borrowing and firms’ net worth.

Consider first the existence of liquidity constrained consumers. Suppose that a propor-
tion λ of consumers are credit constrained and have no income from monopolistic retail
firms. They must consume out of wage income and their consumption is given by

The remaining Ricardian consumers are modelled as before and consume C2_,t . Total con-
sumption is then

Ct = λC1_,t + (1 - λ)C2_,t                              (41)

We can model the risk premium rigorously and financial stress by introducing a financial
accelerator. The main ingredient is an external finance premium Θ_t such that when the

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