more contractionary monetary stance so investment and Tobin’s Q fall by less. Aggregate
consumption includes that of entrepreneurs in models II and III and their fall in net worth
sees consumption fall sharply in these two models and this reduces output demand still
further. The main differences in IRFs for the risk premium shock is then between model I
without a financial accelerator and models II and III which have this feature.
6 Discussion and Future Developments: Open Economy
and Policy
In this chapter, we put forward a methodology to help understanding of India’s business
cycle. Though well rooted in the empirical New Keynesian DSGE framework, we discuss
a number of novel features that address issues that are emerging-economies (and India, for
that matter) specific. Indeed, the introduction of, on one hand, financial frictions in the
form of liquidity constrained consumers and a financial accelerator mechanism, and, on the
other hand, the distinction between a formal and an informal sector are not only realistic,
but also conducive to a better empirical performance.
Nevertheless, there are limitations to our study. First, we believe that in the case of
emerging economies, the role of trends in the data requires special attention. Andrle (2008),
for example, argues that assumptions on trending behaviour should be explicitly modelled,
rather than side-stepped by means of an ad-hoc filtering procedure. Alternatively, one can
take an agnostic view regarding de-trending in DSGE models by following the one-step
approach recently suggested by Ferroni (2010), in which filtering parameters are jointly es-
timated with structural parameters, thus allowing for formal statistical comparisons among
different de-trending procedures.
Second, by confining our analysis to a closed-economy model, we leave out important
sources of fluctuations. As with any open economy, emerging market economies are affected
by external shocks. In addition, they are also vulnerable to sudden and sharp reversals
of capital inflows, the “sudden stops” highlighted in Calvo (1998). Understanding these
differences and carefully modeling the transmission mechanism of internal and external
shocks is crucial to the understanding of real business cycle fluctuations and the design of
stabilization policy.
In a series of papers, Batini et al. (2007), Batini et al. (2009) and Batini et al. (2010a),
the authors develop a two-bloc model of an emerging open economy interacting with the rest
of the world. The Indian economy is small in relation to the world economy and is therefore
treated as a small open economy. Alongside standard features of small open economies
(SOE) such as a combination of producer and local currency pricing for exporters and oil
imports, their model incorporates financial frictions in the form of a financial accelerator,
where capital financing is partly or totally in foreign currency, as in Gertler et al. (2003)
and Gilchrist (2003). This intensifies the exposure of a SOE to internal and external
shocks in a manner consistent with the stylized facts listed above. In addition, they allow
29