ABSTRACT
In the previous chapter we examined a standard model of stabilisation and growth to show how it is not growth-inducive. However the previous exercise being a simulation model for a cross-section of DEs, we intend to model the inter-relations between trade and inflation in this chapter for the Indian economy using a modelling strategy which develops structural econometric models via sequential reduction of a congruent vector auto regressive data representation. The Indian economy went through severe fiscal and external imbalances in the summer of 1991. On July 4, 1991 the Government of India undertook the major task of fundamentally altering its development paradigm by announcing a massive dose of devaluation and other major policies aimed at reducing the fiscal deficit and the current account deficit. These two instruments, namely reducing the Central bank credit to the Government (which is the major source of financing the fiscal deficit) and devaluing the currency are the standard instruments currently employed in many countries that are undergoing BOP crises. The basic questions that arise in this context are: (i) whether devaluation or reduction in domestic credit is a solution to BOP crisis? (ii) by how much should the Government reduce its credit leading to reduction in fiscal deficit? and, (iii) by how much should the Government devalue the Indian rupee? In other words, can we evaluate alternative devaluation strategies? Thus the major focus of this chapter is to answer these quantitative economic questions following the policy model of Sundararajan (1986) [henceforth VS]. But our study is different from VS in the sense that VS did not pay any attention to the question of stationarity while dealing with the time series. This comment also applies to the subsequent studies following VS (Murty and Prasuna, 1994; Paul, 1994; Verma, 1994).
