Sources of Uncertainty and the Indian Economy

Indian economy is exposed to various forms of uncertainty. Theories of investment underuncertainty and real options predict that increased uncertainty tends to depress real investment.Literature finds that uncertainties regarding oil price and real exchange rate adversely affect domestic capital formation. The socio-economic realities of India together with the lack of penetration of formal financial institutions make gold as a one of the main modes of investment for Indian households. However, over-investment in gold may have adverse consequences for the real economy as it drives away resources from productive capital. Moreover, higher inflation uncertainty makes it harder to extract information from the price system and thus may reduce economic efficiency. In this paper, we use a bivariate GARCH-in-mean VAR model to estimate the interrelationships of various uncertainty measures and the real economy. We find that the Indian economy is not particularly vulnerable to real exchange rate or oil price uncertainties.However, gold price uncertainty has a significant positive effect on output growth. Higher WPI inflation uncertainty is detrimental to growth rates of private consumption expenditure and gross capital formation. Moreover, a rise in the growth rate of government expenditure following a positive CPI inflation shock may partially explain the lack of any detrimental effect on output growth.