Public Investment and Private Capital Formation in a Growth Model – A VECM Approach Applied to India

S. K. Shanthi, C.N. M. Lavanya

Abstract


In this paper, we study the long-run and short-run relationships between public sector capital formation and private sector capital formation in a framework of growth. The results assume importance in the current Indian context of growth slowdown as they have policy implications. We have used annual data sourced from the Reserve Bank of India’s publications, for the period 1952-53 to 2009-10. All the variables namely, public sector capital formation, private sector capital formation and GDP at factor cost, are in real terms with base year 2004-05. The methodology we have used is the Johansen–Juselius approach (1990) of estimating the Trace statistics and the maximal eigen values to identify the number of co-integrating relationships, subsequent to the verification of stationarity of the series using the Augmented Dickey Fuller test. In our case, all the variables were found to be stationary in the first differences indicating that they are I(1) processes. The Johansen–Juselius co-integration test results indicate the presence of one co-integrating relationship with r = 1. This methodology has become quite standard in the literature where macroeconomic variables are modeled. It allows us to take care of some of the fundamental problems of co-movements of many of the macroeconomic variables. Following this methodology, the Vector Error Correction Models (VECMs) for all the three variables with a trend in cointegration were estimated and the underlying relationships were identified. During the time period under consideration, India also went through a major change in 1990-91, that of liberalization. While this could have led to a break in the trend, our test for shift in trend gave negative results indicating no shifting trend. We show that there is a positive long-run impact of private capital formation in levels and in terms of lags on growth while the long-run public capital formation has a seemingly negative impact on growth. Following Sims et al., it has also become standard to test for causality. The causality tests indicate that there is no causality running from real GDP or even the other way around. Public capital formation is found to significantly Granger-cause private capital formation.

 

Keywords: Capital Formation, Augmented Dickey Fuller Test, Co-integration, VECM, Causality

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