A little over forty years ago, when I joined the Planning Commission, Prof. Chakravarthi asked me to formulate a model for short term macro-policy analysis. My response was in the genre of a monsoon compensation model -not quite a one-good macro model but a model with two sectors —agriculture and nonagricultural.

In this model agriculture, in the short run, was modelled as fixed quantity and flexible price sector, the fixed quantity depending on the monsoon and agricultural prices being determined by domestic demand and supply. Non-agriculture in the short run, on the other hand,  was modelled as fixed price  flexible quantity sector, output and capacity utilisation being determined by effective demand given the impact of the monsoon determined agricultural growth.

A small departure from the fixed price formulation of the non-agricultural sector came through the modelling of the impact of agricultural prices on budgetary resources and on non-agricultural prices via wages and raw material costs. The impact of international terms of trade was also considered as part of cost push inflation. But given the lower ratio of international trade to GDP, this was not of great consequence for short term macro policy, except occasionally when abnormal  price shocks occurred.

The challenge of short term macro-economic management is now radically different.  Formulating a model or even a conceptual framework for macro-economic policy today must take into account the following key difference between then and now

• In the mid-seventies agriculture constituted 38% of our GDP.  Now that proportion is down to 17% of GDP. Monsoon compensation or terms of trade related income shifts are not as important a consideration for macroeconomic policy.
• Exports and imports were 41% of GDP in 2016-17 as against 12% of GDP forty years earlier. With a much larger part of the economy connected to the world economy and far fewer quantity controls on foreign trade, exchange rate management and fiscal and monetary policies that affect relative domestic costs become an important part of macro policy.
• From the International side, another major change is importance of private international capital flows. In the national accounts the net inflow of capital from the rest of the world as a proportion of gross fixed investment averaged to 6.8% during the first five years of this decade. The gyrations of the share market are heavily influenced by foreign portfolio flows. Hence the impact of macroeconomic policies on foreign perceptions acquires additional salience.
• In 1976-77 public sector investment was 9.8% of GDP while private corporate investment was just one 1.5% of GDP.  Managing investment forty years ago was an internal public sector exercise. This direct ability to manage aggregate investment has been diluted by the shift in these proportions to  7.4 % of GDP for the public sector and 11% for the private corporate sector.

Clearly we need a different approach to macro economic stability in an economy that is more open, more private sector oriented and much less monsoon dependent. On the analogy of monsoon compensation we can conceptualise macro economic policy in an open economy as world economy compensation. This requires a clear understanding of the links between exchange rates, foreign capital flows and domestic aggregate demand supply balance.

A useful framework thinking about this is provided by a diagram first formulated by the Australian economist Trevor Swan. This diagram (with the original terminology modified slightly) has relative domestic prices on the vertical axis and the fiscal deficit on the horizontal axis . If domestic costs are high relative to foreign costs, there will be a current-account deficit and ,to ensure that domestic demand equals full employment supply, the fiscal deficit would have to be higher. That is why the internal balance line slopes upwards. The requirement for external balance is the opposite—high relative domestic costs require a tight fiscal policy to contain demand so as to keep the current account deficit in check.

Above the internal balance line there is a deficiency of demand and below it, a threat of inflation. As for external balance, above the line relative costs and/or the fiscal deficit are at a level that would lead to a current account deficit, and vice-versa below the line. Swans diagram was developed for an economy with open capital flows. Hence interest rates were assumed to be set exogenously by global conditions and the need to prevent reserve depletion.

There are some modifications one has to make in the Swan framework to apply it to Indian conditions today.  First our capital account is not fully open.  A degree of independence is available for interest-rate policy and one would want to add a third axis for the domestic interest rate. External balance would now be not just on current-account but also on capital-account with interest rates affecting not just  domestic demand but also foreign capital flows. As for internal balance the impact of interest rates would be not just on current demand but also on growth potential.

Applying it to Indian conditions today one could argue that we are in the top quadrant - demand deficiency and a current account deficit. Moving towards a balance requires a fiscal stimulus and an interest rate reduction that can stimulate demand (but is controlled enough to calm nervous foreign bankers) and an exchange rate policy that improves relative domestic cost advantage.

The broader policy message is clear. The pursuit of macro economic stability cannot be  based on simplistic fiscal deficit or inflation targets. Exchange rate management, the interest rate set by the central-bank, the fiscal stance of the government must be set in the light of prevailing global and domestic conditions rather than be bound down by unconditional rules.

Post script: Trevor Swan and I overlapped for a year at Southampton University in 1968.  He had one of the sharpest minds I have ever known. As a 'remembrance of times past' I offer Swan’s Way of explicating internal and external balance as a useful tool for thinking about macro economic policy today.