Context: Recently, the Reserve Bank of India (RBI) is using Dynamic Stochastic General Equilibrium (DSGE) model to provide a tentative and proximate assessment of the likely impact of Covid-19 and the subsequent lockdown on the Indian economy.
About DSGE Model

• DSGE modelling is a method in macroeconomics that attempts to explain economic phenomena, such as economic growth and business cycles, and the effects of economic policy, through econometric models based on applied general equilibrium theory and economic principles.
• Econometrics is the application of statistical methods to economic data in order to give empirical content to economic relationships.
• General Equilibrium Theory is a macroeconomic theory that explains how supply and demand in an economy with many markets interact dynamically and eventually culminate in an equilibrium of prices.
• RBI has considered three main economic agents, viz., households, firms and the government.
• Because of lockdown, households have to stay at home and therefore, reduced labour supply to firms and consumption and income fall due to non-availability of non-essential items.

Possible Scenarios under the DSGE Model

• First scenario i.e lockdown I which impacts the supply side of the economy by decreasing the labour supply and its productivity.
• Second scenario i.e lockdown II, which additionally considers the increase in marginal cost i.e. the additional cost incurred in the production of one more unit of a good or service.
• Inflation is expected to decline under both the first and second scenario.
• Under the first scenario production cut is less severe, but demand contraction is more pronounced due to a rise in infections.
• In the second scenario firms will curtail production as profits take a hit, wages see a lower rise and the economy goes through a large contraction.
• However, the recovery from the pandemic is faster in the lockdown scenario on account of fewer opportunities for people-to-people interactions.

RBI has calibrated the DSGE model for the above two scenarios by assuming that:

• Covid-19 infections peak around the second half of August 2020.
• The output gap (difference between the actual and the potential output) reduces to about 12% of potential output when the economy is worst hit.
• In both the scenarios of two lockdowns, the decline in economic activity reaches its bottom in April-June quarter of 2020-21 and recovers thereafter, with growth turning gradually positive from January-March quarter 2020-21.
• Third scenario i.e the government does not impose a lockdown, the pandemic is more widespread and peaks in the second half of January 2021 with a very slow recovery.
• This will cause a persistent labour shortage and the supply shock will increase the inflation and reduce the output.