Monetary and Fiscal Policy in the Presence of Informal Labour Markets

NIPFP Working Paper 97
[PDF]

Nicoletta Batini, Paul Levine, Emanuela Lotti and Bo Yang
November 2011

Abstract

How does informality in emerging economies affect the conduct of monetary and fiscal policy? To answer this question we construct a two-sector, formal-informal new Keynesian closed-economy. The informal sector is more labour intensive, is untaxed, has a classical labour market, faces high credit constraints in financing investment and is less visible in terms of observed output. We compare outcomes under welfare-optimal monetary policy, discretion and welfare-optimized interest-rate Taylor rules alongside a balanced-budget fiscal regime. We compare the model, first with no frictions in these two markets, then with frictions in only the formal labour market and finally with frictions on both credit markets and the formal labour market. Our main conclusions are first, labour and financial market frictions, the latter assumed to be stronger in the informal sector, cause the time-inconsistency problem to worsen. The importance of commitment therefore increases in economies characterized by a large informal sector with the features we have highlighted. Simple implementable optimized rules that respond only to observed aggregate inflation and formal-sector output can be significantly worse in welfare terms than their optimal counterpart, but are still far better than discretion. Simple rules that respond, if possible, to the risk premium in the formal sector result in a significant welfare improvement.

Monetary and Fiscal Policy in a DSGE Model of India

NIPFP Working Paper 96
[PDF]

Paul Levine and Joseph Pearlman
November 2011

Abstract

We develop a optimal rules-based interpretation of the ‘three pillars macroeconomic policy framework’: a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies. The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions. It is calibrated using India and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules. A comparison with a fixed exchange rate regime is made. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy. These policy prescriptions contrast with the monetary-fiscal policy stance of the Indian authorities.

An Estimated DSGE Model of the Indian Economy

NIPFP Working Paper 95
[PDF]

Vasco Gabriel, Paul Levine, Joseph Pearlman and Bo Yang
November 2011

Abstract

We develop a closed-economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods using Dynare. We build up in stages to a model with a number of features important for emerging economies in general and the Indian economy in particular: a large proportion of credit-constrained consumers, a financial accelerator facing domestic firms seeking to finance their investment, and an informal sector. The simulation properties of the estimated model are examined under a generalized inflation targeting Taylor-type interest rate rule with forward and backward-looking components. We find that, in terms of model posterior probabilities and standard moments criteria, inclusion of the above financial frictions and an informal sector significantly improves the model fit.

Informal Labour and Credit Markets: A Survey

NIPFP Working Paper 94
[PDF]

Nicoletta Batini, Young-Bae Kim, Paul Levine and Emanuela Lotti
November 2011

Abstract

This paper reviews the literature on the informal economy, focusing first on empirical findings and then on existing approaches to modelling informality within both partial and general equilibrium environments. We concentrate on labour and credit markets, since these tend to be most affected by informality. The phenomenon is particularly important in emerging and other developing economies, given their high degrees of informal labour and financial services and the implications these have for the effectiveness of macroeconomic policy. We emphasize the need for dynamic general equilibrium (DGE) and ultimately dynamic stochastic general equilibrium (DSGE) models for a full understanding of the costs, benefits and policy implications of informality. The survey shows that the literature on informality is quite patchy, and that there are several unexplored areas left for research.

Millenium Development Goals: How is India Doing?

NIPFP Working Paper 93
[PDF]

Sudipto Mundle
November 2011

Growth and Election Outcomes in a Developing Country

NIPFP Working Paper 92
[PDF]

Poonam Gupta and Arvind Panagariya
October 2011

Abstract

With the exception Brander and Drazen (2008), who use a comprehensive cross-country database consisting of both developed and developing countries, the hypothesis that rapid growth helps incumbents win elections has been tested exclusively for the developed countries (e.g., Ray Fair 1978). But since sustained rapid growth offers the prospect of pulling vast numbers of the voters out of poverty within a generation, such an effect is far more likely to be present in the developing rather than developed countries. In this paper, we offer the first test of the hypothesis on a large developing and poor country, India, which has seen its economy grow 8 to 9 percent recently. We first generalize the Fair model to allow for multiple candidates instead for just two and then test it using cross-state data. We find quantitatively large and statistically robust effect of growth on the prospects of the candidates of the state incumbent parties to win elections. Specifically, we use the data on 422 candidates in the 2009 parliamentary elections and show that the candidates of incumbent parties in high-growth states have much better prospects of victory than those in low-growth states.

Civil Service and Military Pensions in India

NIPFP Working Paper 91
[PDF]

Renuka Sane and Ajay Shah
September 2011

Tracking Indian Growth in Real Time

NIPFP Working Paper 90
[PDF]

Rudrani Bhattacharya, Radhika Pandey and Giovanni Veronese
July 2011

Abstract

Tracking growth in the Indian economy would be best performed using a measure like GDP. Unfortunately official estimates of this indicator are released with quarterly frequency and with considerable delay. This paper compares different approaches to the short term forecasting (nowcasting) of real GDP growth in India and evaluates methods to optimally gauge the current state of the economy. Univariate quarterly models are compared with bridge models that exploit the available monthly indicators containing information on current quarter developments. In the forecasting exercise we perform a pseudo real-time simulation: by properly taking into account the actual publication lags of the series, we replicate the information set available to the policymaker at each point of time. We find that bridge models perform satisfactorily in predicting current quarter GDP growth. This result follows from the actual estimation technique used to construct the official quarterly national accounts, still largely dependent on a narrow information set. Our analysis also suggests mixed evidences about the additional predictive power of Indian survey data with respect to the hard data already used in the national accounts.

Who cares about the Chinese Yuan?

NIPFP Working Paper 89
[PDF]

Vimal Balasubramaniam, Ila Patnaik and Ajay Shah
May 2011

Abstract

The rise of China in the world economy and in international trade has raised the possibility of a rise of the Yuan as an international currency, particularly after the Chinese authorities have undertaken policy initiatives such as Yuan settlement and Yuan swap lines. In this paper, we measure one dimension of Yuan internationalisation: the role of the Yuan in the exchange rate arrangements of other economies. While the magnitudes are small, our findings show that as many as 34 currencies in the world have been sensitive to movements in the Yuan. This suggests that the Yuan potentially has a significant role to play in global exchange rate arrangements. Contrary to popular belief, however, we find a limited role of the Yuan among Asian economies.

Has India Emerged? Business Cycle Facts from a Transitioning Economy

NIPFP Working Paper 88
[Link]

Chetan Ghate, Radhika Pandey, and Ila Patnaik
April 2011

Abstract

This paper presents a comprehensive set of stylised facts for business cycles in India from 1950-2009. We find that the nature of the business cycle has changed dramatically after India's liberalisation reforms in 1991. In particular, after the mid 1990s, the properties of India's business cycle has moved closer in key respects to select advanced countries. This is consistent with India's structural transformation from a pre-dominantly agricultural and planned developing economy to a more market based industrial-income economy. We also identify in what respects the behavior of the Indian business cycle is different from that of other advanced economies, and closer to that of other less developed economies. This is the first exercise of this kind to generate an exhaustive set of stylised facts for India using both annual and quarterly data.

Did the Indian Capital Controls Work as a Tool of Macroeconomic Policy?

NIPFP Working Paper 87
[Link]

Ila Patnaik and Ajay Shah
April 2011

Abstract

In 2010 and 2011, there has been a fresh wave of interest in capital controls. India is one of the few large countries with a complex system of capital controls, and hence offers an opportunity to assess the extent to which these help achieve goals of macroeconomic and financial policy. We find that the capital controls were associated with poor governance, were unable to sustain the erstwhile exchange rate regime, and did not support financial stability. India's experience is thus inconsistent with the revisionist view of capital controls. Macroeconomic policy in India has moved away from the erstwhile strategies, towards greater exchange rate flexibility combined with capital account liberalisation.

Panchayats and Economic Development

NIPFP Working Paper 86
[PDF]

M. Govinda Rao and T.R. Raghunandan
March 2011

Stimulus, Recovery and Exit Policy G20 Experience and Indian Strategy

NIPFP Working Paper 85
[PDF]

Sudipto Mundle, M. Govinda Rao and N. R. Bhanumurthy
March 2011

Federalism and Fiscal Reform in India

NIPFP Working Paper 84
[PDF]

M. Govinda Rao and Tapas K. Sen
February 2011

Abstract

This paper attempts to analyse the experience of incentivising economic reforms at the state level through central transfers to states. It reviews the experiences of the central government introducing incentives for reform directly through various specific purpose transfers as well as the incentive schemes recommended by various Finance Commissions. The incentive schemes directly introduced by the central government include, accelerated irrigation benefit programme, accelerated power development and reform programme, Jawaharlal Nehru Urban Renewal Mission, education and health sector reforms. The reforms recommended by the Finance Commissions include incentivising tax reforms and fiscal restructuring and consolidation.

The review of the experiences of Indian fiscal federalism shows that the incentivising reforms have neither been an unqualified success nor have they been a total failure. There are interesting lessons to be learnt from the experiences for both designing the incentive schemes and implementing them. The paper summarises the lessons of experience. While incorporating these in designing and implementing incentive schemes can be useful in the short and medium term, what matters in the long run is the political incentive for reforms.

How to Measure Inflation in India?

NIPFP Working Paper 83
[PDF]

Ila Patnaik, Ajay Shah and Giovanni Veronese
February 2011

Abstract

What is the best inflation measure in India? What inflation measure is most relevant for monetary policy making in India? Questions of timeliness, weights in the price index, accuracy of food price measurement, and inclusion of services prices are relevant to the choice of measure. We show that under present conditions of measurement, the Consumer Price Index for Industrial Workers (CPI-IW) is preferable to either the Wholesale Price Index or the GDP deflator.

Indian Social Democracy: The Resource Perspective

NIPFP Working Paper 82
[PDF]

Vijay Kelkar and Ajay Shah
February 2011

Deficit Fundamentalism vs Fiscal Federalism: Implications of 13th Finance Commission’s Recommendations

NIPFP Working Paper 81
[PDF]

Pinaki Chakraborty
January 2011

Abstract

The Thirteenth Finance Commission’s recommendation to increase the vertical share of tax devolution to states will help, but its horizontal distribution formula leaves much to be desired. One, its design is such that two of the four key indicators are in conflict with each other. Two, the Commission’s revised road map for fiscal consolidation at the centre and the states, which recommends state-specific, year-wise, fiscal adjustment paths, not only limits the fiscal manoeuvrability of states but also impinges on their fiscal autonomy. Three, its design of the grant for elementary education has the potential to reduce the expenditure of states rather than augment it. The need to look at intergovernmental transfers from the right perspective of federalism, where the states and the centre are seen as equal partners in development and not from a narrow technocratic viewpoint, cannot be stressed more.

Reforming the Indian Financial System

NIPFP Working Paper 80
[PDF]

Ajay Shah and Ila Patnaik
January 2011

India's Financial Globalisation

NIPFP Working Paper 79
[PDF]

Ajay Shah and Ila Patnaik
January 2011

Abstract

India embarked on reintegration with the world economy in the early 1990s. At first, a certain limited opening took place emphasising equity flows by certain kinds of foreign investors. This opening has had myriad interesting implications in terms of both microeconomics and macroeconomics. A dynamic process of change in the economy and in economic policy then came about, with a co-evolution between the system of capital controls, macroeconomic policy, and the internationalisation of firms including the emergence of Indian multi-nationals. Through this process, de facto openness has risen sharply. De facto openness has implied a loss of monetary policy autonomy when exchange rate pegging was attempted. The exchange rate regime has evolved towards greater flexibility.

Monetary Policy Transmission in an Emerging Market Setting

NIPFP Working Paper 78
[PDF]

Rudrani Bhattacharya, Ila Patnaik and Ajay Shah
January 2011

Abstract

Some emerging economies have a relatively ineffective monetary policy transmission owing to weaknesses in the domestic financial system and the presence of a large and segmented informal sector. At the same time, small open economies can have a substantial monetary policy transmission through the exchange rate channel. In order to understand this setting, we explore a unified treatment of monetary policy transmission and exchange-rate pass-through. The results for an emerging market, India, suggest that the most effective mechanism through which monetary policy impacts inflation runs through the exchange rate.

Export Versus FDI in services

NIPFP Working Paper 77
[PDF]

Rudrani Bhattacharya, Ila Patnaik and Ajay Shah
January 2011

Abstract

In the literature on exports and investment, most productive firms are seen to invest abroad. In the Helpman et al. (2004) model, costs of transportation play a critical role in the decision about whether to serve foreign customers by exporting, or by producing abroad. We consider the case of tradable services, where the marginal cost of transport is near zero. We argue that in the purchase of services, buyers face uncertainty about product quality, especially when production is located far away. Firm optimisation then leads less productive firms to self-select themselves for FDI. We test this prediction with data from the Indian software industry, and find support for it.