Indian Fiscal Policy: A DSGE Primer

This paper reviews contemporary literature on theoretical modelling of fiscal policy in India, and highlights the inadequacy of studies focusing on fiscal issues through the lens of Dynamic Stochastic General Equilibrium (DSGE) modelling. Next, in order to stimulate further discussion, the paper proposes a ‘primer’ DSGE model calibrated for the Indian economy with focus on exploring fiscal policy transmission, and the economy-wide impact of shocks in various fiscal instruments is evaluated and compared. Finally, drawing from this primer model, the paper discusses areas of future research in context of recent developments in India’s fiscal policy framework. This includes rethinking the modelling of the fiscal rule, and honing the estimation methodology. The paper proposes a small open economy New Keynesian DSGE framework, with the building blocs of households, producing, assembling, and investment firms, government and the central bank. The government has a number of fiscal instruments at its disposal – government consumption, government investment, transfers, public employment, consumption tax, and labor income tax – governed by a fiscal rule for fiscal deficit. The parameters are calibrated from data, past studies on the Indian economy, and formulation from steady state relationships and the model is simulated with the motivation of examining the impact of fiscal shocks. The study finds that while output and employment increases in response to positive spending shocks, the impact on consumption is mixed, while private investment stimuli uniquely leads to increase in private investment. The impact of tax stimuli differ – a negative consumption tax shock is disinflationary and positively impacts consumption, while the study observes asymmetric impact of negative shock in labor income tax cut, given its limited tax coverage. From the perspective of policy relevance, these results highlight the pros and cons of various forms of fiscal intervention based on the nuances of their policy transmission. Within spending shocks, public investment stimulus avoids crowding out of private investment, while a cut in consumption tax offers a more direct impact on household consumption. Finally, while the model herein offers an intuitive framework for assessing Indian fiscal policy transmission using DSGE modelling, the paper concludes by outlining areas of further research.