Business Cycle Accounting for India in a Multi-Sector Dynamic General Equilibrium Model

Abstract

The Indian economy’s remarkable growth experience since the last decade, which continues through today, has been a source of continuous empirical research. While several studies have been conducted in an attempt to explain the underlying triggers, general equilibrium analysis of growth using business cycle accounting is a new technique. The objective of this method is not only to figure out the primitives that have brought about the economic growth in India, but the channels through which these primitives were transmitted. This question is relevant since the liberalization policies in the decade of eighties and nineties are thought of as catalysts to growth. But did the policies affect productivity or did they reduce labor market frictions or did they lower investment friction in the economy? This paper provides answer to these questions by modeling the frictions as wedges or divergence from first-best conditions and feeding them in various combinations to see which of them can replicate data. The results indicate that primitives affected the Indian economy through productivity channels in all sectors, especially the service sector. Labor market frictions, investment frictions and government expenditures have limited role to play in enhancing growth. The multi-sector framework enriches the single sector analysis done before, by reflecting the sector where the impact of productivity has been the highest. Additionally, I look at the long-term “trend” component of growth and come to the same conclusion as that in the business cycle accounting exercise - the service sector productivity has been the primary transmission channel. The results obtained here emphasize the importance of the service sector productivity from a policy standpoint. Overall economic growth of the Indian economy has been propelled by the service sector and hence policies tailored towards enhancing the productivity of this particular sector are of immense importance.