An Estimated DSGE Model of the Indian Economy.

firm equates the expected return with the expected cost of borrowing we have

Et[1 + Rk,t+1] = Et[Θt+1(1 + Rt+1)]

where                      Θt = k ^μ-N-) -^λ                       (43)

Qt-1Kt

is our chosen functional form. In (43), N_t is net worth and Q_t-1K_t -N_t is the external
financing requirement. Thus Q^t- ¹Kt-N^t is the leverage ratio and thus (42) and (43) state
that the cost of capital is an increasing function of this ratio. Bernanke et al. (1999), in a
costly verification model, show that the optimal financial contract between a risk-neutral
intermediary and entrepreneur takes the form of a risk premium given by (43). Thus the
risk premium is an increasing function of leverage of the firm. Following these authors, in
the general equilibrium we ignore monitoring costs.

We now introduce entrepreneurs who own the capital of wholesale firms and who exit
with a given probability 1 - ξ_e . Then the net worth accumulates according to

Nt+1 =ξeVt+(1-ξe)Dt^e

where D_t^e are transfers from exiting to newly entering entrepreneurs continuing, and V_t , the
net value carried over from the previous period, is given by

V_t = (1 + R_k,t)Q_t-1K_t - Θ_t(1 + R_t)(Q_t-1K_t -N_t)            (45)

where Rk,t is the ex post return given by

WW

⁽¹ - ^αI ) -p_r- ~K_r ^{+ (1} - ^δ ) Qt

^{1 +} R^k∙^t = ---------Q-_l----------

Demand for capital is then given by

Finally, exiting entrepreneurs consume the residual equity so that their consumption

Ct =    ^ Nt

ξ_e

must be added to total consumption. The full model is summarized in Appendix A with
the previous model as a special case.

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