Tight credit policy versus currency depreciation: Simulations from a trade and inflation model of India

Using a small macroeconometric model that examines the determinants of India's trade and inflation, this paper addresses the effects of a reform policy package similar to those implemented in 1991. Policy simulations using dynamic simulation method compare the responses to devaluation with the responses to tight credit policy. It is shown that the trade balance effects of tight credit policy are more enduring than that of devaluation, conditional on inflation being modelled in an open economy context. The simulations demonstrate that the devaluation actually worsens trade balance and hence devaluation cannot be an option in response to a negative trade shock, whereas the reduction in domestic credit reflecting demand contraction can produce a desirable improvement in the trade balance.