An Estimated DSGE Model of the Indian Economy.

This allows for the possibility of some tax incidence in the informal sector, but in fact we
proceed on the basis on the informal sector is untaxed, so τI,t = 0.

Introducing labour market frictions, we assume that the real wage in the formal sector
given by a real wage norm RW_t that is a mark-up rw on the real wage in the informal

Ft?’= = RW_t = (1 + rw ) ^-It ; rw > 0

Pt                    Pt

From RW_t > WPp^t-, it follows from ULL < 0 that the household will choose less leisure and
more work effort in the formal sector; i.e., hF_,t   > hI_,F .

Capital is accumulated by capital-producing firms out of F-output as before. Again we
model the risk premium by introducing financial accelerators in each sector with different
parameters.

The remaining difference to be considered is the demand side of the model. We construct
Dixit-Stiglitz consumption and price aggregates

where μ is the elasticity of substitution between I and F goods, and w is the relative
weight of consumers in their preferences. Then standard inter-temporal and intra-temporal
optimizing decisions lead to

c_Ft = w μ PP^t )^μ Ct

Cι,t = (1 - w) μ PPt )^μ c_t

Let T_t = pp_t be the relative price of the retail consumption basket in the two sectors.
Then we have

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[w + (1 - w)Tt^{1 -μ}i ~^μ

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where Πi,t , i = I , F and Πt are sector and CPI inflation rates respectively. We assume that

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