Macro economic effects of public investment in infrastructure in India

K. N. Murty
A. Soumya
Working Paper series No. WP-2006-003
JEL codes: 
This paper attempts to build an aggregative, structural, macroeconometric model for India. Investment and output in the model are disaggregated into four sectors, viz., (a) agriculture including forestry & fishing, (b) manufacturing, (c) infrastructure, which includes power, transport, communication and construction and (d) services sector, covering all other activities. The model emphasizes the interrelationships between internal and external balances and also the relation between money, output, prices and balance of payments. A unique feature of the model is that it incorporates the savings-investment identity. The model also tries to link economic growth with poverty reduction. Annual time series data for the period 1978-79 to 2002-03 are used for this purpose. Three-stage least squares method is used to estimate the model. The model is validated for its in-sample forecasting ability. A few counter factual policy simulations relating to public investment in infrastructure are undertaken to illustrate the usefulness of the model for analyzing the policy options in a simultaneous equations framework. A preliminary trend analysis has shown slowing down of the economy during 90s and thereafter. There are also significant structural shifts in production from agriculture to infrastructure and services in the Indian economy. The estimated model indicated significant crowding-in effect between private and public sector investment in all the sectors. Counter factual policy simulations of sustained increase in public sector investment in infrastructure, financed through borrowing from commercial banks, shows substantial increase in private investment and thereby output in this sector. Further, due to increase in absorption, real output in the manufacturing and services sectors also seem to increase, which sets-in motion all other macro economic changes. Due to rise in sectoral (and aggregate) output, price level and money supply seem to decline in the short-run. Due to sustained nature of the policy change, the impacts get strengthened over time and benefit the economy. A 10% sustained increase in public sector investment in infrastructure, which is less than 0.4% of GDP, can accelerate the macro economic growth by nearly 2.5% without causing any inflation. Further, this increase in income will lead to nearly 1% reduction in poverty in India. This re-assures the potential for achieving the much debated 10% aggregate real GDP growth in the Indian economy.