An Estimated DSGE Model of the Indian Economy.

misspecified, as shown by Fernandez-Villaverde and Rubio-Ramirez (2004).² Finally, this
framework provides a straightforward method of evaluating the ability of the models in
capturing the cyclical features of the data, while allowing for a fully structural approach to
analyse the sources of fluctuations in the Indian economy.

We find that a model incorporating financial frictions and a formal-informal sector
distinction fits the data well and delivers sensible structural parameter estimates. This, in
our opinion, should constitute the first step in the construction of models suitable for the
systematic analysis of policy actions.

Indeed, the role of fiscal policy cannot be properly understood, discussed and assessed
unless these specific features, of which we provide a basic framework, are taken into account.
Concurrently, monetary policy in India is difficult to encapsulate in conventional policy
rules, given the broad scope of the Reserve Bank of India’s (RBI) mandate (controlling
inflation, managing pressures on the exchange rate and coping with capital flows). We
discuss how a generalized policy rule can be used to capture (and evaluate) the RBI stance,
our results suggesting that India’s monetary authority policy actions appear to aggressively
target expected inflation, albeit at a short term horizon.

Thus, in the next section, we describe a baseline New Keynesian DSGE and estimate
it with US and Indian data, illustrating the differences between these two economies. In
section 3, we introduce liquidity constrained consumers and a financial accelerator mecha-
nism into the baseline model. Then, in section 4, we develop a two-sector model allowing
for informality and compare the empirical performance of the competing models. The final
section summarizes our findings and points directions for further study.

2 A Standard NK Model

This section develops a standard New Keynesian (NK) DSGE model without any features we
associate with emerging economies. To give us a preliminary insight into what is different
about an emerging economy such as India, this benchmark model is then estimated by
Bayesian methods using both Indian and US data.

2.1 The RBC Core

Every NK DSGE model has at its core a real business cycle model, describing the inter-
temporal problems facing consumers and firms and defining what would happen in the
absence of the various Keynesian frictions. We first define a single-period utility for the
representative agent in terms of consumption, Ct , and leisure, Lt , as

² This is an important methodological point, given that the models discussed in this paper, by focusing
only on the closed economy and therefore omitting open economy features, are inherently ‘misspecified’.

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