An Estimated DSGE Open Economy Model of the Indian Economy with Financial Frictions



We develop an open economy DSGE model of the Indian economy and estimate it by Bayesian Maximum Likelihood methods. 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, “liability dollarization” and incomplete exchange rate pass-through. Our estimation results support the inclusion of financial frictions in an otherwise standard small open economy model. 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.


Indian economy Open economy DSGE model Bayesian estimation Monetary interest rate rules Financial frictions 

JEL Classification:

E52 E37 E58 


  1. Adolfson, M., Laseen, S., Linde, J., & Villani, M. (2008). Evaluating an estimated new Keynesian small open economy model. Journal of Economic Dynamics and Control, 32(8), 2690–2721.CrossRefGoogle Scholar
  2. Adrian, T., & Shin, H. S. (2009). Money, liquidity, and monetary policy. American Economic Review, 99(2), 600605.CrossRefGoogle Scholar
  3. Agenor, P., McDermott, C. J., & Prasad, E. S. (2000). Macroeconomic fluctuations in developing countries: Some stylized facts. The World Bank Economic Review, 14(2), 251–285.CrossRefGoogle Scholar
  4. Aguiar, M., & Gopinath, G. (2007). Emerging market business cycles: The cycle is the trend. Journal of Political Economy, 115, 69–102.CrossRefGoogle Scholar
  5. Andrle, M. (2008). The role of trends and detrending in DGSE models. manuscript.Google Scholar
  6. Barro, R., & Sala-i-Martin, X. (2004). Economic growth (2nd ed.). McGraw-Hill.Google Scholar
  7. Batini, N., Gabriel, V., Levine, P., & Pearlman, J. (2010a). A floating versus managed exchange rate regime in a DSGE model of India. University of Surrey Working Paper.Google Scholar
  8. Batini, N., Levine, P., & Pearlman, J. (2010b). Monetary Rules in Emerging Economies with Financial Market Imperfections. NBER Conference Volume, J. Gali & M. Gertler (Eds.), International dimensions of monetary policy. University of Chicago Press.Google Scholar
  9. Benigno, P. (2001). Price stability with imperfect financial integration. CEPR Discussion Paper no. 2854.Google Scholar
  10. Bernanke, B., Gertler, M., & Gilchrist, S. (1999). The Financial Accelerator in Quantitative Business Cycles. In M. Woodford & J. B. Taylor (Eds.), Handbook of macroeconomics (Vol. 1C). Amsterdam: Elsevier Science.Google Scholar
  11. Bhattacharya, R., Patnaik, I., & Shah, A. (2010). Monetary policy with a weak transmission mechanism. Working Paper, National Institute for Public Finance and Policy.Google Scholar
  12. Brooks, P., & Gelman, A. (1998). General methods for monitoring convergence of iterative simulations. Journal of Computational and Graphical Statistics, 7(4), 434–455.Google Scholar
  13. Brozoza-Brzezina, M., Kolasa, M., & Makarski, K. (2013). The anatomy of standard DSGE models with financial frictions. Journal of Economic Dynamics and Control, 37, 32–51.CrossRefGoogle Scholar
  14. Calvo, G., & Mishkin, F. S. (2003). The mirage of exchange rate regimes for emerging market countries. Journal of Economic Perspectives, 17(4), 99–118.CrossRefGoogle Scholar
  15. Calvo, G. A. (1998). Capital flows and capital-markets crises. Journal of Applied Econometrics, 1(1), 35–54.Google Scholar
  16. Carlstrom, C. T., & Fuerst, T. S. (1997). Agency costs, net worth and business cycle fluctuations: A computable general equilibrium analysis. American Economic Review, 87, 893–910.Google Scholar
  17. Castillo, P., Montoro, C., & Tuesta, V. (2013). An estimated stochastic general equilibrium model with partial dollarization: A bayesian approach. Open Economies Review, 24 (217–165),Google Scholar
  18. Cespedes, L. F., Chang, R., & Velasco, A. (2004). Balance sheets and exchange rate policy. American Economic Review, 94(4), 1183–1193.CrossRefGoogle Scholar
  19. Chin, M., Filippeli, T., & Theodoridis, K. (2015). Cross-country co-movement in long-term interest rates: A DSGE approach. Staff Working Paper No. 530, Bank of England.Google Scholar
  20. Christiano, L. J., Trabandt, M., & Walentin, K. (2011). Introducing financial frictions and unemployment into a small open economy model. Journal of Economic Dynamics and Control, 35(12), 19992041.CrossRefGoogle Scholar
  21. Cook, D. (2004). Monetary policy in emerging markets. Journal of Monetary Economics, 51(6), 1155–1181.CrossRefGoogle Scholar
  22. Cúrdia, V., & Woodford, M. (2010). Credit spreads and monetary policy. Journal of Money, Credit and Banking, 42, 3–35.CrossRefGoogle Scholar
  23. Del Negro, M., & Schorfheide, F. (2004). Priors from general equilibrium models for VARs. International Economic Review, 45, 643–673.CrossRefGoogle Scholar
  24. Del Negro, M., & Schorfheide, F. (2008). Forming priors for dsge models (and how it affects the assessment of nominal rigidities). Journal of Monetary Economics, 55(7), 11911208.Google Scholar
  25. Del Negro, M., Schorfheide, F., Smets, F., & Wouters, R. (2007). On the fit of new keynesian models. Journal of Business and Economic Statistics, 25(2), 123–162.CrossRefGoogle Scholar
  26. Devereux, M. B., Lane, P. R., & Xu, J. (2006). Exchange rates and monetary policy in emerging market economies. The Economic Journal, 116(511), 478–506.CrossRefGoogle Scholar
  27. Elekdag, S., Justiniano, A., & Tchakarov, I. (2005). An estimated small open economy model of the financial accelerator. IMF Discussion Paper No. WP/05/44.Google Scholar
  28. Fernandez-Villaverde, J. (2009). The econometrics of DSGE models. CEPR Discussion Paper No. 7159.Google Scholar
  29. Fernandez-Villaverde, J., & Rubio-Ramirez, J. F. (2004). Comparing dynamic equilibrium models to data: A Bayesian approach. Journal of Econometrics, 123, 153–187.CrossRefGoogle Scholar
  30. Ferroni, F. (2011). Trend agnostic one-step estimation of dsge models. B.E. Journal of Macroeconomics, 11(1), 1690–1935.CrossRefGoogle Scholar
  31. Gabriel, V., Levine, P., Pearlman, J., & Yang, B. (2012). An estimated model of the Indian economy. In C. Ghate (Ed.), Chapter in the “Handbook of the Indian Economy”. Oxford University Press.Google Scholar
  32. Gabriel, V. J., Levine, P., & Spencer, C. (2009). How forward-looking is the fed? Direct estimates from a ‘Calvo-type’ rule. Economics Letters, 104(2), 92–95.CrossRefGoogle Scholar
  33. Gali, J. (2008). Monetary policy, inflation and the business cycle. Princeton University Press.Google Scholar
  34. Gali, J., Lopez-Salido, J., & Valles, J. (2004). Rule-of-thumb consumers and the design of interest rate rules. Journal of Money, Credit and Banking, 36(4), 739–764.CrossRefGoogle Scholar
  35. Gertler, M., & Karadi, P. (2011). A model of unconventional monetary policy. Journal of Monetary Economics, 58(1), 17–34.CrossRefGoogle Scholar
  36. Gertler, M., & Kiyotaki, N. (2012). Banking, liquidity and bank runs in an infinite horizon economy. Princeton University: Mimeo, NYUGoogle Scholar
  37. Gertler, M., Gilchrist, S., & Natalucci, F.M. (2003). External constraints on monetary policy and the financial accelerator. NBER Working Paper No. 10128.Google Scholar
  38. Geweke, J. (1999). Computational experiments and reality. University of Minnesota and Federal Reserve Bank of Minneapolis.Google Scholar
  39. Iacoviello, M. (2005). House prices, borrowing constraints, and monetary policy in the business cycle. American Economic Review, 95(3), 739–764.CrossRefGoogle Scholar
  40. Jaimovich, N., & Rebelo, S. (2009). Can news about the future drive the business cycle? American Economic Review, 99(4), 10971118.CrossRefGoogle Scholar
  41. Aoki, K., & J. P. and Vlieghe, G., (2004). House prices, consumption, and monetary policy: A financial accelerator approach. Journal of Financial Intermediation, 13(4), 414–435.Google Scholar
  42. Kiyotaki, N., & Moore, J. (2007). Credit cycles. Journal of Political Economy, 105(2), 211–248.CrossRefGoogle Scholar
  43. Levin, A., Onatski, A., Williams, J.C., & Williams, N. (2006). Monetary policy under uncertainty in micro-founded macroeconomic models. In M. Gerler & K. Rogoff (Eds.), NBER Macroeconomics Annual, 2005 (pp. 229–387).Google Scholar
  44. Levine, P., McAdam, P., & Pearlman, J. (2007). Inflation forecast rules and indeterminacy: A puzzle and a resolution. International Journal of Central Banking, 3, 77–110.Google Scholar
  45. Litterman, R. B. (1983). A random walk, markov model for the distribution of time series. Journal of Business and Economics Statistics, 1(2), 169–173.Google Scholar
  46. Mallick, S. (2011). Macroeconomic shocks, monetary policy and implicit exchange rate targeting in india. Mimeo: Queen Mary University of London.Google Scholar
  47. Mishkin, F. S. (2006). The next great globalization: How disadvantaged nations can harness their financial systems to get rich. Princeton, NJ: Princeton University Press.Google Scholar
  48. Neumeyer, P. A., & Perri, F. (2005). Business cycles in emerging economies: The role of interest rates. Journal of Monetary Economics, 52, 345–380.CrossRefGoogle Scholar
  49. Schorfheide, F. (2000). Loss function-based evaluation of DSGE models. Journal of Applied Econometrics, 15(6), 645–670.CrossRefGoogle Scholar
  50. Shah, A. (2008). New issues in macroeconomic policy. NIPFP Working Paper No. 51.Google Scholar
  51. Smets, F., & Wouters, R. (2003). An estimated stochastic dynamic general equilibrium model of the euro area. Journal of the European Economic Association, 1(5), 1123–1175.Google Scholar
  52. Smets, F., & Wouters, R. (2007). Shocks and frictions in US business cycles: A Bayesian DSGE approach. American Economic Review, 97(3), 586–606.CrossRefGoogle Scholar
  53. Virmani, V. (2004). Operationalising Taylor-type rules for the Indian economy: Issues and some results. Indian Institute of Management Ahmedabad Working Paper 2004-07-04.Google Scholar

Copyright information

© Springer India 2016

Authors and Affiliations

  1. 1.University of SurreySurreyUK
  2. 2.Swansea UniversitySwanseaUK

Personalised recommendations