INTRODUCTION TO MACROECONOMICS [With Application to Bangladesh Economy] Kazi Iqbal Amin Bin Hasib To Our colleagues of General Economics Division (GED) and Support to Sustainable and Inclusive Planning (SSIP) project, UNDP Introduction to Macroeconomics [With Application to Bangladesh Economy] ii PREFACE This textbook is an output of the ‘Support to Sustainable and Inclusive Planning (SSIP)’project of the General Economics Division (GED), Planning Commission, GoB, funded by UNDP- Bangladesh. One of the objectives of this project is to expand the capacity of the public planners so that the planners have the basic understanding on how an economy works, particularly a developing economy like Bangladesh. With better understanding of the economy and the public policies, planners will be able to analyze the economic issues with greater rigor and confidence and this will be reflected in crafting national policy documents. With this broad goal in mind, the Senior Economist of the SSIP project Dr. Kazi Iqbal started teaching a course on the principles of macroeconomics to the officials from General Economics Division in 2014-15. Amin Bin Hasib provided excellent research support and helped add flesh to each chapter. A. Z. M. Saleh provided valuable editorial support. This textbook is the collation of the expanded version of the class notes prepared for the course taught at GED. What makes this textbook unique is that it is written to understand the economy and macroeconomic policies of Bangladesh while maintaining the standard of the undergraduate level textbook on the principles of macroeconomics. Most of the examples and relevant issues are drawn from Bangladesh economy. Given the broad scope and importance of the issues, two chapters – chapter 4 and chapter 9 are fully dedicated to review the banking sector and fiscal policies of Bangladesh respectively, after explaining the relevant concepts and issues. A separate chapter (chapter 5) has been written on stock price bubble and burst with reference to 1996 and 2010-11 stock market debacles of Bangladesh. We believe that this issue should be included in the introductory text book of macroeconomics in Bangladesh and should become a standard common knowledge of the mass people. Once we become familiar with the process how a bubble generally forms and how it bursts, it will help us to spot the next one and avoid becoming an ignorant participant in it. We know that all macroeconomic variables are linked through both accounting and behavioral relationships. We think introductory macroeconomics should offer the pedagogical tool to understand the accounting relationships among macro variables while appreciating the behavioral relationships among them. All major actors in the economy - households, businesses, government, commercial banks and central bank are connected through their balance sheets (accounting relationships) and action of one actor affects the balance sheet of the others. We think one should understand this accounting relationships first before exploring more complex behavioral relationships. In this light, we particularly focus on the balance sheets of the commercial banks and the central bank in explaining monetary economics. The linkages between these two balance sheets are central to the understanding of how monetary policy works. We highlight this point in the textbook in several occasions with examples from a commercial bank and the central bank of Bangladesh. It is well understood that the use of textbooks designed to explain the issues and policies of the developed countries (e.g., USA, EU) in teaching introductory macroeconomics fails to motivate the students of a developing country like Bangladesh, largely because the students cannot connect what they read in textbook with what they observe around them or encounter in everyday life. As a result, the students learn only a few definitions, concepts and theories, Introduction to Macroeconomics [With Application to Bangladesh Economy] iii but don’t know how to use them in explaining real world problems. We believe this textbook will help students appreciate that the tools learnt in economics are in fact useful in explaining real world issues and making policies. Who are the right audience of this book? Typically, it is an introductory level macroeconomics book for the first year undergraduate students in economics. However, some of the chapters go beyond the introductory level without introducing any technical rigor. This book can also be used to teach in Masters of Development Studies type program where students have little background in economics. In fact, all public planners and development practitioners will find this book useful for their professional development. The textbook has 13 chapters. We hope to include one more chapter on poverty and inequality in the next version. The discourse on the macroeconomic issues in a developing country cannot be complete without knowing their distributional implications. Despite having a plan to include the historical context of the Indian sub-continent of the issues such as national income accounting, banking, money, etc., we could not do it due to time constraint. We hope to include it in the next version as we think that it will motivate the students greatly. All the data and information used in the textbook are not up-to-date as the course at GED was taught in 2014-15 and also due to time constraint. We have a plan to create a databank which will contain all updated data used in this book and it will be made available online so that students can play around with this data. This is the first cut of the book which is yet to include exercises. We will teach this book for a couple of years before finalizing it. We believe that we will be able to meet the demand of the students only when this book is taught several times. Your comments to enrich the content of the book will be highly appreciated. General Economics Division (GED) Bangladesh Planning Commission Government of the People’s Republic of Bangladesh Introduction to Macroeconomics [With Application to Bangladesh Economy] iv TABLE OF CONTENTS CHAPTER 1 .................................................................................................................................................................. 1 What is macroeconomics all about? ...................................................................................................................... 1 1.1 Two broad questions ............................................................................................................................. 1 1.2 Economic Growth: A Brief Overview ................................................................................................. 2 1.3 Economic Fluctuations (Business Cycle) and Policies ...................................................................... 5 CHAPTER 2 ................................................................................................................................................................ 10 Measuring Standard of Living: National Income .............................................................................................. 10 2.1 Robinson Crusoe Economy and Its National Income (Product) ................................................... 10 2.2 National Income Accounting ............................................................................................................. 12 2.3 Gross Domestic Product (GDP) ......................................................................................................... 12 2.3.1 Nominal GDP ............................................................................................................................. 14 2.3.2 Real GDP ..................................................................................................................................... 14 2.3.3 Nominal and real GDP of Bangladesh .................................................................................... 15 2.3.4 GDP Deflator............................................................................................................................... 16 2.3.5 The Three Approaches of Measuring GDP ............................................................................. 17 2.3.6 Components of GDP revisited .................................................................................................. 21 2.3.7 Other National Accounts ........................................................................................................... 26 2.3.8 Shortcomings of GDP ................................................................................................................ 27 2.4 Relationship between Saving and Investment ................................................................................ 30 2.4.1 Simple Economy ......................................................................................................................... 30 2.4.2 Economy with Government and International Trade ........................................................... 30 2.4.3 Twin Deficit ................................................................................................................................. 32 CHAPTER 3 ................................................................................................................................................................ 35 Saving and Investment: ........................................................................................................................................