Empirical Application of a Flow of Funds Model for India
We construct data for a flow of funds model and estimate a complete model of disaggregated sectors’ portfolio choice with associated policy simulations for India. The methodological steps are taken as follows. Firstly, we estimate a system of demand functions which uses as framework the Almost Ideal Demand System based on the compiled flow and stock data for individual sectors of banks, other financial institutions, private corporate business and household with six financial instruments by demand functions. Secondly, by consolidating all the estimated models of disaggregated sectors, a system-wide flow of funds model is constructed where each financial market is solved by the market clearing conditions. Thirdly, using the system-wide flow of funds model, stochastic policy simulation experiments are conducted in order to investigate the appropriate policy instruments for financial development in India.
The estimated model provides coherent and plausible parameter estimates for prices and other variables. We find that a standard portfolio model can usefully be applied to the study of financial behaviour in a developing economy such as India, and some interesting policy implications can be drawn. Stochastic simulation enables us to examine the impact of uncertainty in policy implementation, and the robustness of policy in the presence of uncertainty. The estimated range of outcomes gives a clear picture of the policy risks a government may face in carrying out financial reforms, and we find substantial differences between the results of stochastic simulations and those of equivalent ‘naïve’ deterministic simulations.