Speaker : Dr. Sheshadri Banerjee (NCAER)
What are the driving forces of business cycle fluctuations? How do these drivers interact with the movement of output? What are the determining factors for the relative importance of these drivers in the business cycle? We address these three research questions considering Indian economy as the test bed. A small open economy New Keynesian DSGE model is developed, which features external habit formation, investment adjustment cost, home bias in consumption and investment, and staggered price setting behaviour of firms. The model includes five types of shocks, namely, total factor productivity (TFP), investment specific technology (IST), fiscal spending, home interest rate, and foreign interest rate. Using the Bayesian methodology, we estimate the model for the annual data over the period of 1971 – 2010, and for the sub-samples of pre-liberalization (1971 – 1990) and post-liberalization (1991 – 2010) periods. Our analysis reveals three key results. First, technology shocks, consisting of TFP and IST, are the primary sources of cyclical fluctuations in India. In contrast, the demand side disturbances play a very limited role due to weak transmission channels. Second, output correlates positively with the shocks to TFP, but negatively with the IST shocks. Finally, the sub-sample analysis indicates that though TFP shocks dominate in absolute term, there is an increasing relative importance of the IST shocks in driving fluctuations during post-liberalization era. It is found that structural shifts of nominal friction and relative home bias for investment to consumption in the post-liberalization period can account for the rising predominance of the IST shocks in India.