Modelling a flow of funds and policy simulation experiments in the financial sector for India

The objective of this thesis is to analyse policy effects on the financial sector in India by modelling a flow of funds for four sectors with six financial instruments for the period of 1951–1993 with associated simulation techniques. In the general equilibrium model, the whole financial sector is endogenised by means of demand functions for asset choice in the four sectors and each financial market is solved by the market clearing conditions. An important innovation is that the Almost Ideal Demand System (AIDS) is utilised for a system of demand function, and cointegration techniques are adapted into the econometric methodology. The policy simulation experiments are conducted with a view to analysing the delivery of loanable funds to sectors which are the most in need of poverty-reducing economic growth, at the same time, they are largely in line with the financial reforms that started in the early 1990s in India. The system-wide simulation designed in this thesis will permit us to analyse a wide spectrum of policy effects on such issues as the determinant of interest rates, financing capital formulation, the role of financial institutions, government debt and allocation of credit, as a result of interactions in the disaggregated economic sectors. The key finding is the significant role of interest rates in portfolio selection and thereby on the flow of funds for India. The policy simulations, however, reveal that the liberalisation of interest rates may be no better than the administered rates in ensuring loans to private sectors. Possible perverse outcomes from the liberalised interest rate regime are also highlighted in the stochastic simulations, as policies become sensitive or fragile in the face of uncertainty in the economy. These demonstrate the importance of a gradual de-regulation in the financial sector, rather than an indiscriminate attempt at financial decontrol.