Central banking in a transitory economy: an adaptive control model for India

The purpose of this paper is to formulate a policy model for the Indian economy, incorporating an expectation generating mechanism in a formal way. The aim is to see how policies will change over time when the expectation of the private sector is changing. In a mixed economy planning has to take into account how the private sector formulates and revises its expectation regarding various government policies and their possible impacts on the endogenous variables (or target variables) in the economy. Normally in an economy like India's the government formulates its plan for the public sector over the next five years. The government can regulate the private sector by various means, such as licences, investment quotas, tax-subsidy rates, bank interest rates and by various monetary controls. The private sector, knowing the targets of the government, formulates its own expectations regarding the fulfulments of the targets (because it never expects that the government can fulfil its targets exactly) and possible movements of various policies. It behaves according to its expectations and realization of past expectations and thus allocates its resources. So the optimum design of public policies should be to direct the private sectors towards the desired goals defined by the planners, taking into account the reactions of the private sector. The purpose of public policy in such an environment should be to formulate different central bank policies regarding money stock, credit expansion and components of the money multiplier along with government discount rate, and the exchange rate so that the private sector would react in the desired way, given the goals set by the planners regarding national income, balance of payments, domestic absorptions and prices.