A Simple Model of Macroeconomic Instability in the Background of the Indian Economy

The article first looks at the working of an open economy under a situation of price flexibility in a static framework. This extends the Mundell–Fleming model and shows the effect of exchange rate movement in a richer perspective. The article then introduces the role of depreciation of domestic currency in increasing cost of production by increase in the cost of imported inputs and shows the possibility of multiple equilibria. This could lead to the emergence of an economic crisis in a country that is dependent on critical imported input and also suffering from current account deficit. If the outstanding loan amount of this economy is also large, the chances of a crisis are extremely high and policymakers should introduce measures with all earnestness to set right the situation. The article then considers a dynamic version of the macroeconomic model and shows a variety of equilibria. Although the usual case is one of global stability, there may be saddle point stability as well in several cases where (a) depreciation of currency increases price substantially and (b) confidence of the economy is low. But the most critical case could be one under current account deficit when foreign exchange reserves start declining. Here there is saddle point instability and if the confidence level of the economy is low, the economy could be prone to crisis. The article concludes that the Indian economy, in its current state, is exhibiting similar characteristics.JEL Classification: F41, E32