Macro economic effects of public investment in infrastructure in India

K. N. Murty, A. Soumya
JEL codes: 
Working Paper series No. WP-2006-003

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.