government services are provided by the formal sector. Then output equilibrium in both
sectors is given by
YF,t = CF,t+Gt+It
YI,t = CI,t
The pricing dynamics in the two sectors follows as before, as do the shock processes, but
now we have mark-up, technology and risk premia shocks in both sectors. The model is
closed with an inflation targeting rule for CPI inflation. The full model is summarized in
Appendix B. Figure 1 illustrates the interconnections of this model structure.
Figure 1: Two-Sector NK Model Structure
4.2 Bayesian Estimation for India
The model discussed above introduces further transmission mechanisms that may be im-
portant for the conduct of monetary policy. Thus, we now assess how well this extended
model fits the data for India. Note that we now have several structural parameters defined
for both the formal and informal sectors. In particular, we wish to ascertain the differences
20
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