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Foreign Capital Inflow and Economic Growth: A Two Gap Model for
the Bangladesh EconomyAuthor(s): S AhmadSource: The Bangladesh
Development Studies, Vol. 18, No. 1 (March 1990), pp.
55-79Published by: Bangladesh Institute of Development
StudiesStable URL: http://www.jstor.org/stable/40795371 .Accessed:
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The Bangladesh Development Studies Vol. XVIII, March 1990, No.
1
Foreign Capital Inflow and Economic Growth: A Two Gap Model for
the
Bangladesh Economy* S AHMAD**
This paper attempts to examine the effect of foreign capital
inflow on growth of output, domestic saving, imports and production
structure. In doing so, a simultaneous equation model for the
Bangladesh economy in the framework of the dual gap analysis has
been estimated using the time series data for the period
1960/61-1979/80. It is found that foreign capital inflow was
conducive for economic growth. It has substituted domestic saving
as' the government might have relaxed saving efforts with its
inflow. It increased the productive capacity of the economy
financing the development projects. It facilitated the expansion of
the tertiary sector. The increased services I rom the tertiary
sector along with increased imports of raw materials and
intermediate goods (financed by it.) increased output in the
primary and manufacturing sectors. Thus foreign capital inflow
changed the production structure of the economy with resulting
changes in the composition of GDP, exports and imports.
I. INTRODUCTION
A few but important constraints to growth faced by almost all
the less developed countries (LDCs) are shortages of skilled
manpower, domestic saving and foreign exchange. Chenery and Bruno
(1962), Chenery and Adelman (1966), Chenery and MacEwan (1966) and
Chenery and Strout (1966) have examined in the framework of two-gap
(deficient saving and foreign exchange) models how foreign capital
inflow is capable of easing the saving and foreign exchange
constraints and thus has a positive contribution to economic growth
of LDCs. Their two-gap approach to growth is critically evaluated
by among others Bruton (1969), Fei and Ranis (1968), Findlay
(1973), Luxton (1979), Rahman (1967) and Quibria (1981). But it is
not evaluated by anybody with respect to impact of foreign capital
inflow on strategic variables which affect economic growth. In this
respect, the two-gap approach misses some essential points which
are presented below.
This article is mainly based on a few chapters of the author's
Ph. D. dissertation. The author is grateful to Dr. Robert C. Rice
and an anonymous referee for their useful comments. lie is
responsible for remaining errors and omissions.
"Associate Professor, Department of Economics, University of
Dhaka, Dhaka- 1000, Bangladesh.
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56 The Bangladesh Development Studies
Firstly, all the studies on the two-gap theory concentrate on
how foreign capital inflow removes the binding constraint and has a
favourable impact on the economic growth of a LDC. But growth of
output is not the only variable which foreign capital inflow can
affect. Moreover, growth is usually affected by changes in such
strategic variables as domestic saving, imports, exports,
production structure of the economy, etc. None of the dual gap
models have estimated the impact that foreign capital inflow has on
these strategic variables.
Secondly, in two-gap models, foreign capital inflow performs the
role of suplementing, instead of substituting, domestic saving in
investment as it is seen to finance only required imports. But in a
LDC like Bangladesh where the two-gap exists, a significant portion
of foreign capital inflow finances imports of consumer goods to
save millions of people from starvation and malnutrition. When
foreign capital inflow finances imports of consumer goods, the
additive hypothesis in a two-gap model that the sum of foreign
capital inflow and domestic saving equals investment becomes
questionable.
Thirdly, almost all the studies on the dual gap analysis have
treated the required imports as one aggregate variable in the
models. The required imports consist of imports of intermediate and
capital goods. While imports of intermediate goods are essential
for utilization of the existing productive capacity in a LDC, the
imports of capital goods are necessary for creation of additional
productive capacity. In a LDC with two gaps, consumer goods are
also imported. The financing of these three categories of imports
with foreign capital normally has divergent effects on growth of
output, gross domestic saving (GDS), exports and production
structure of an economy. To take care of these effects in the
analysis of the effects of foreign capital inflow on the overall
economic growth, it is proper to use the three categories of
imports (namely, imports of consumer, intermediate and capital
goods) in the two-gap model.
Fourthly, per capita income rises with the growth of an economy.
With the increase in per capita income, the demand for final
consumer goods increases, and so does the input requirement for
production. Again a rise in the per capita income would be
accompanied by changes in the production structure. If this changed
production structure is unable to meet the demand for final
consumer goods and input requirements, imports would increase. So
import demand arises not only due to the level of income but also
due to inability of the domestic production structure to match the
domestic demand. Thus, to explain the import demand, the production
structure should be explicitly taken into consideration. Hardly any
dual gap models has done this.
Fifthly, the growth process passes through different phases and
in each phase growth is limited by one dominant constraint.
Different phases of the growth process are characterized by
different production structures. In each phase the production
structure partially determines the saving-investment and foreign
exchange gaps. These gaps are partly closed by foreign capital
inflow, which, in turn, changes the production structure through
increases in investment. Thus, foreign capital inflow affects the
growth process through changes in the production structure. Again
changes in the production
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Ahmad : Foreign Capital Inflow and Economic Growth 57
structure in response to internal and external demand are likely
to change exports and imports. They are expected to affect domestic
saving, saving of foreign exchange and growth. Therefore, the
growth process and the production structure are interdependent. To
take care of such interdepen- dence, the production structure
should be incorporated in the two-gap model for analysing the
growth process in LDCs.
Finally, the estimation of equations in the two-gap models are
based on the single equation method (SEM). But the SEM is incapable
of taking into account the interdependence among variables. In
fact, the variables involved in the growth process for instance,
consumption, domestic saving, investment, imports, exports,
production structure, etc. are interdependent. To take of such
interdependence, a simultaneous equation model can be used and
estimated using a simultaneous equation method (SIMEM).
The purpose of the present paper is to test the following
hypotheses with reference to Bangladesh using a two-gap model which
incorporates the above points:
(1) Foreign capital in How is conducive to growth of output. (2)
Foreign capital inflow has a positive effect on domestic saving.
(3) Foreign capital inflow positively affects the availability of
all cartegories
of imports, not just imports of intermediate and capital goods.
(4) Foreign capital inflow affects the production structure.
In testing the hypotheses, an estimating model is presented in
Section II, estimation of the estimating model is discussed in
Section III, the empirical findings are analysed in Section IV and
finally a conclusion is added in Section V.
II. THE ESTIMATING MODEL
Our estimating model is deduced from the basic two-gap model
consisting of ten behavioural equations, one equilibrium condition,
ten definitional variables and four identities which were presented
and discussed in Ahmad (1986, pp. 125-158). Details about its
derivation were given in Ahmad (1986, pp. 158- 164). The variables
included in the basic two-gap model are the following.
Endogenous Variables : Q=total output, AQ = change in total
output, QJ3 =output in the primary sector, *
qJ11 = output in the manufacturing sector, QP/Qt = share of the
primary sector
in total output, Q |/Qt = share of the manufacturing sector in
total output.
*The primary sector in the present study is defined to include
agriculture, forestry, fishery, livestock, mining, and quarrying.
The manufacturing sector includes both small and large scale
manufacturing industries. The tertiary sector includes all the
sub-sectors except those included in the primary and manufacturing
sectors and hence is considered as the residual one. For instance,
it includes the sub-sectors: construction, power, gas, water and
sanitary services; transport, storage and communications; trade
services; housing services: banking and insurance; public
administration and defence; professional and miscellaneous se
naces.
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58 The Bangladesh Development Studies
T C Qt/Qt = share of the tertiary sector in total output, M ,=
imports of
r k consumer goods, Mj = imports o intermediate goods, M , =
imports of
capital goods, ML = total imports, St = gross domestic saving,
Yt = per capita output, It = investment of domestically produced
capital goods, Kt =
capital stock and the exogenous variables :
Xt = total exports of goods and services It = gross investment,
N( = population size, Ct = total consumption expenditure, M* =
imports of services including net factor payments. Ft =
foreign capital inflow defined as the deficit in the current
account of the balance of payments, Pj = area cropped,
Gt=government recurring expenditure Dt = depreciation, Kt_j =
capital stock in the previous year. In addition, the subscript t
denotes the time period. All the endogenous and exogenous variables
are in real terms.
In initial ordinary least squares (OLS) runs the disturbance
terms in the growth, domestic saving and import demand functions of
the basic two-gap model are found to violate the assumption of
homocedasticity. For this reason the variables in these functions
are expressed as proportions of total output in the estimating
model. As the disturbance terms of the structural equations for the
production structure in the basic two-gap model satisfy the
assumption of homocedasticity they are retained unchanged in the
estimating model. To be consistent with the equations 1-4 of the
estimating model, the variables in the rest of the relations of the
basic two-gap model are expressed as proportions of total output.
However, the estimating model is given below.
1. Growth Function for Binding Saving Constraint
AQt S( Ft Mt ""
= K /o " + Wo q[" ( (xoo /g) qT + e 1 1
Growth Function for Binding Foreign Exchange Constraint
AQ( X Ft M W M op AQ( =(/g) p +(/g) gj-
Ft - (o/g) Q^-(IWg) (IWg) - + elt 9t Qt
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Ahmad : Foreign Capital Inflow and Economic Growth 59
2. Domestic Saving Function
St AQt Xt F, T=s + m2 "T+a2 r+fi2 r+2t
3. Import Demand Function
(, < ct of o" M" xt Pt Qt
^ Qt Q, 9,
** ^
Mt AQ( Xt Ft (ii) - = m4 op +a4 ^ + 4 f +E4t
Mt it 9t xt Ft () ~ =m5 OT +d5 - + a5 Q
- h Qf + 5t
4. Production Structure
P k 9t Mt X, F,
(i) - = m6 + d6 log y{ + c6 log pt + r|6 + (x6 ^ + 6 ^
Qt Qt
e!11 Q x, Ft (ii) = m7 + d7 log y( + c7 log + t' log N( + a - +
7 - + e?t Qt Qt M Wt
Qt AQ( Gt Xt F, (iii) - =m8 + d8 - +C8 ^ + gj-
+ 8 ^ ,8(
5. Exports
X, %
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60 The Bangladesh Development Studies
6. Gross Investment
Q =
Q
7. Per Capita Output
y, = Qi/n,
8. Population Size
N, = ,
9. Total Consumption Expenditure
Q "
Q
10. Imports of Services
11. Foreign Capital Inflow
II II Qi
= Qt
12. Area Cropped
p. = pi
13. Govt. Revenue Expenditure
q = a 9, s, Mf M Mf 9? 9tm qJ
Endogenous Variables : rr-, y y q" , - , , . . .
y y Qt Qt Qt Qi Qt Qt
Exogenous Variables : ^j-, ~
Yr Nt q
Q ' Pt ' Q
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Ahmad : Foreign Capital Inflow and Economic Growth 61
To derive the estimating model, the constrained investment
function, equilibrium condition and all the identities are used.
Because of this, they are dropped from the estimating model. It is
not also necessary to keep them in the estimating model while the
purpose of the model is only to analyse the past. Thus the
estimating model has eight equations to determine eight endogenous
variables.
III. ESTIMATION OF THE ESTIMATING MODEL
We have examined the identifiability of the equations of our
estimating model. Using the necessary condition for identification,
we have found every equation of the model identified. Even though
the necessary condition is not sufficient for identification, it is
usually considered for identification in practice. Ahmad (1983) has
found domestic saving as the dominant constraint to
growth in Bangladesh during the period under study. We have
estimated the saving constrained version of our estimating model
using time series data2 for the period 1960/61 -1979/80. In
estimating the model the Ordinary Least Squares (OLS) method, First
Order Autoregressive Method (FOAM), Two-Stage Least Squares (2SLS)
and Three-Stage Least Squares (3SLS) methods have been used. We
have followed the Hildreth-Lu search procedure (Hildreth and Lu
1960) in the FOAM estimation and Zellner and Theils method (Zellner
and Theil 1962) in the 3SLS estimation.
The OLS and FOAM methods may be termed as single equation method
(SEM) while the 2SLS and 3SLS methods may be termed as simultaneous
equation methods (SIMEM). Apart from the fact that single equation
estimates are subject to bias, they are also presented and
discussed. There are two reasons for doing so. Firstly, most of the
findings on the relationships between foreign capital inflow, on
the one hand and economic variables of the present study on the
other, are based on the SEM. Our single equation estimates are,
therefore, expected to serve the comparative purposes. Secondly, we
like to find out the extent of the difference between the single
equation estimates and the simultaneous equation estimates when the
same data are used. Such a differencece is expected because the
single equation estimates include only the direct effect of
explanatory variable (s) while the simultaneous equation estimates
take account of total (both direct and indirect) effects. However,
the results obtained by the SEM and SIMEM are given in Tables 1, 2
and 3, Appendix A.
The coefficients of the SEM and the 2SLS method are very similar
both in sign and magnitude; but the coefficients obtained by the
3SLS method widely differ from those of the SEM (i.e., OLS and
FOAM) and the 2SLS method; some cases in sign, some cases in
magnitude and some cases in both sign and magnitude. These
differences may be attributed to the following factors. Firstly,
the 3SLS method takes account of both the direct and indirect
effects
2 Relevant data that were used in estimation of the estimating
model ean be obtained from the author on request.
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62 The Bangladesh Development Studies
of a variable in the system of simultaneous equations. Secondly,
there may exist some specification errors in some equations in the
estimating model. Specification errors arise due to inclusion of an
irrelevant variable or omission of a relevant variable in an
equation, or choice of a linear relation among the variables in an
equation while the true relation is in fact, non -linear. It is
very difficult to eliminate the specification error in a particular
equation where inclusion of an independent variables is usually
dictated by the theoretical considerations, and where choice of a
linear model is the rule of the social sciences in the face of lhe
complexity and difficulties of the non-linearities. Thirdly, the
3SLS method assumes that the disturbance term in every equation of
the simultaneous equation model satisfies the assumptions of the
classical OLS method. But in some equations of our model, the
disturbance terms are autocorrelated but in other equations they
are not. In the absence of a suitable method of computation to
estimate such simultaneous equations, we have to use Zellner and
Theil's 3SLS method which is partially inappropriate due to some
autocorrelated disturbance terms.
It may be noted that the results of the SEM and 2SLS method are
more dependable than those of the 3SLS method because of likely
presence of specification errors in some equations of the
estimating model and partial inappropriateness of Zellner and
Theil's method in the 3SLS estimation. Since our sample size is
small and we know little about the small sample properties of the
2SLS and 3SLS estimators (Pindyck and Rubinfeld 1981, p. 338), our
findings on the basis of the 2SLS and 3SLS methods are
tentative.
The whole of the period 1960/61-1979/80 may be divided into two
sub- periods, namely the pre-liberation period (1960/61 - 1969/70)
and the post- liberation period (1972/73-1979/80). Both the
sub-periods differ to some extent with respect to economic, social
and political institutions and policies. Furthermore, the data for
the years 1970/71 and 1971/72 are not available. For these reasons
a dummy variable (using 1 for each year of the pre-liberation
period and 0. otherwise) is introduced in each equation estimated
with use of data covering the period 1960/61 - 1979/80. It is
retained in the equation only when its inclusion increases R2
irrespective of whether its coefficient is significant or not.
However, a significant dummy variable in a structural equation
suggests that the structural relation differs between the pre- and
post-liberation periods. For instance, a significant dummy variable
in the import demand function for intermediate goods would indicate
that the import demand function for intermediate goods in the
post-liberation period is structurally different from that in the
pre-liberation period.
We have also estimated the model using the SEM and a one-year
lag in F/Q. The variable Ffl/t-l *s considered as simply as an
independent variable in each estimating equation. All the
coefficients of Ft_j/Qt_j are found insignifi- cant at the 5 per
cent level, for which the results are not reported here.
IV. ANALYSIS OF THE EMPIRICAL FINDINGS
Growth of Output/GDP In the estimating model, the growth rate of
GDP is made dependent on the
gross investment rate. The average imported capital coefficient
for gross
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Ahmad : Foreign Capital Inflow and Economic Growth 63
investment is found to be 0.06 (equation 3 (iii). Tables 1 and
2, Appendix A). It is the coefficient between imports of capital
goods and gross investment, both as proportions of GDP, and is
significantly positive al the 10 per cent level. It suggests that
if the gross-investment rate is 100, the import rate for capital
goods on average is 6. In otherwords, imports of capital goods have
formed, on average, about 6 per cent of gross investment in
Bangladesh.
The estimated growth function shows that GDS, foreign capital
inflow and imports of capital goods, all as proportions of GDP,
have positive effects on the growth rate of GDP in Bangladesh
(Tables 1 and 2, equation 1, Appendix A) and the positive
relationships are significant at the 5 per cent level. Thus the
results support the hypothesis that foreign capital inflow is
conducive for growth of output.
The value of R2 for the growth function is veiy low and
negative. The low and negative R2 may be the result of the
estimation of the growth function without intercept. In such a
case, the ratio of explained sum of squares to total sum of sqares
may not be within the range 0 and 1 and hence normal interpretation
for R2 is not valid (Aigner 1971, pp. 85-90). As a result one
cannot suggest that the low R2 for the growth function is an
indication of inadequacy in explaining the growth of GDP by the
variables: GDS, foreign capital inflow and imports of capital
goods. It cannot also be denied that other factors such as
non-availability of skilled manpower, bureaucratic administrative
controls on economic activities, corruption in the administration,
political instability, weather conditions, etc. may explain, to
some extent, the variation of the growth of GDP. These factors are
not included in the growth function as we are interested to
establish a proportional relationship between change in total
output (AQ) and gross investment.
Domestic Saving GDS has played a significantly positive role in
the growth of GDP in
Bangladesh. There are various factors which might have affected
GDS. Among them, growth rate of GDP, foreign capital inflow and
exports as proportion of GDP have explained about 76 per cent of
the saving rate in Bangladesh.
Even though theorectically we expect a positive relationship
between the saving ratio and the growth rate of GDP, we have
obtained a negative relationship between them using the SEM and
2SLS method (Tables 1 and 2, Appendix A) and the negative
relationships are insignificant at the 5 per cent level. The
relationship between the saving ratio and the growth rate of GDP
based on the 3SLS method is also found negative but significant at
the 1 per cent level (Table 3, Appendix A). The growth of the
labour productivity seemed to have increased and hence
worked in the direction of causing the saving ratio to increase
and the increasing dependency ratio in the age structure of
population might have worked in the direction of causing it to
decrease while the other factors such as fiscal inadequacies to tax
the upper income groups rigorously, tax rebates from income
taxation, leakages from the domestic saving, etc. might have
prevented the saving ratio from rising with the growth rate of GDP.
The combined effect of all these factors probably caused the
negative relationship between the saving ratio and the growth rate
of GDP in Bangladesh (Ahmad 1986, pp. 272-273).
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64 The Bangladesh Development Studies
The coefficient of Ft/Q( in the saving function based on the
SEM, 2SLS and 3SLS methods are found to be negative (Tables 1, 2
and 3, Appendix A). The negative coefficients obtained by the SEM
and 2SLS method are significant at the 1 per cent level and that of
the 3SLS method is insignificant at the 5 per cent level. Thus the
effect of foreign capital inflow on GDS appears to be non-
positive. It suggests that the government of Bangladesh might have
relaxed the saving efforts with receipt of foreign capital. Any way
our result does not support the positive relationship between GDS
and foreign capital inflow.
Exports are expected to have a positive effect on GDS. The
coefficients of Xt/Qt based on the SEM, 2SLS and 3SLS methods are
positive but insignificant at the 5 per cent level (Tables 1, 2 and
3 Appendix A). Thus exports appear to have non-negative effects on
GDS. Hence our findings do not contradict the positive relationship
between GDS and exports in the case of Bangladesh even if our data
are insufficient to support it.
Foreign Exchange Allocation A foreign exchange crisis began in
Pakistan after the Korean War in 1952.
Even though Bangladesh in the pre-liberation period accounted
for more than 50 per cent of Pakistan's total foreign exchange
earnings and obtained only one-third of Pakistan's total imports,
it became the victim of Pakistan's foreign exchange crisis being
one of its provinces. Since then Pakistan used to prepare the
foreign exchange budget (FEB) to face the shortage of foreign
exchange. After liberation in 1971 Bangladesh inherited the foreign
exchange budgeting system from Pakistan and used to prepare the
FEB. However, the FEB dealt with free foreign exchange which could
be allocated to finance any part of the import bill. In this sense,
foreign exchange from exports was free whereas that from foreign
assistance and barter trade was not free.
Theoretically we expect a positive relationship between each
category of imports and exports. The coefficients of expports-GDP
ratio based on the 3SLS methods seem to suppt our expectation
(Table 3, Appendix A). The coefficients of exports-GDP ratio based
on the SEM and 2SLS method in the import demand functions for
consumer and intermediate goods are positive and significant at the
5 and 1 per cent levels (Tables 1 and 2, Appendix A). They indicate
that export earnings have positive effects on the availability of
imports of consumer and intermediate goods. Even if the
coefficients of exports-GDP ratio based on the SEM and 2SLS method
in the import demand function for capital goods are negative and
statistically insignificant at the 5 per cent level (Tables 1 and
2, Appendix A), they do not contradict our theoretical expectation
that export earnings have a positive effect on the availability of
imports of capital goods. However, our results appear to suggest
that export earnings financed the imports of all categories of
commodities in Bangladesh. This assertion is supported by the
features of FEB and consequent allocation of foreign exchange for
different categories of imports.3
The coefficient of Ft/Qt based on the SEM, 2SLS and 3SLS methods
are found to be positive and significant at the 1 per cent level in
the import demand functions for intermediate and capital goods
(Tables 1, 2 and 3, Appendix A). But the coefficients showing the
effects of foreign capital inflow on imports of consumer goods have
the expected sign but are statistically ^rhc salient features of
the foreign exchange budget (FEB) and the licensing systems during
the pre- and post-liberation periods can be seen in Ahmad (1986,
pp. 237-246).
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Ahmad : Foreign Capital Inflow and Economic Growth 65
significant at the 5 per cent level (Tables 1, 2 and 3. Appendix
A). Thus our results support the hypothesis that foreign capital
inflow financed all categories of imports in Bangladesh. This is
also corroborated by the features of the FEB in both the pre- and
post-liberation period. Furthermore, the significance of the
coefficients of Ft/Qt in the import demand functions for
intermediate and capital goods and their insignificance in the
import demand function for consumer goods suggest also the
following things. Firstly, foreign exchange was, at least, in past
a constraint to economic development of Bangladesh. Secondly, the
increased availability of foreign capital would not necessarily
increase imports of consumer goods. This is because, it was not
only the availability of foreign capital but also other exogenous
factors such as high restrictions on imports of consumer goods
(except food imports) through foreign exchange control policies,
and the import licensing system, the amount of food deficit in case
of food imports, etc. preventing the free market mechanism from
playing its role freely were important in determining the
availability of consumer good imports with foreign capital inflow.
However, increased availability of foreign capital inflow is most
likely to increase imports of intermediate and capital goods.
The coefficients of ML/Qt in the import demand function for
capital goods have the expected negative sign and are significant
at the 5 and 1 per cent level (Tables 1, 2 and 3, Appendix A). It
indicates that imports of capital goods appear to be given
preferential treatment in foreign exchange allocation over the
imports of consumer goods. Thus our results seem to support the
hypothesis of rational foreign exchange allocation in a situation
of foreign exchange crisis that consumer goods be allowed to be
imported if foreign exchange is available after the import demand
for capital goods has been satisfied.
Import Substitution Bangladesh has almost exclusively dependent
on agriculture in 1947. Still
today it is a food deficit area. Since 1947 industrialization
was the strategy of development. The goal of self-sufficiency in
foodgrains and manufactured products was sought through import
substitution during both pre- and post- liberation period.
In Bangladesh imports of consumer goods increased due to an
increase in total consumption expenditure. This proposition is
supported by the coefficient of Ct/Qt in the import demand function
for consumer goods, because the coefficients of C(/Q( based on the
SEM, 2SLS and 3SLS methods have the expected positive sign and are
significant at the 1 per cent level (Tables 1, 2 and 3, Appendix
A). If the total consumption expenditure as proportions of GDP
increases by 100 per cent, the imports of consumer goods as
proportions of GDP increase by 23 per cent (Tables 1 and 2,
Appendix A). Imports of consumer goods consisted of both
agricultural and manufactured commodities.
Since the variable 9^/Qt is introduced as a proxy variable in
the import demand function for consumer goods to indicate the
presence of import substitution in primary products, its
coefficients are expected to have negative sign. Its coefficients
based on the SEM, 2SLS and 3SLS methods are negative and
significant at the 5 and 1 per cent levels (Tables 1, 2 and 3,
Appendix A).
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66 The Bangladesh Development Studies
They suggest that import substitution occurred in consumer goods
produced in the primary sector, because an increase in primary
production in Bangladesh in a particular year, other things
remaining the same, would increase the primary share in GDP but
decrease imports of primary products, as proportions of GDP, in
that particular year. Such primary products are foodgrains, mainly
rice and wheat (Ahmad 1986, pp. 313-314).
The coefficients of Qm/Qt4 in the import demand function for
consumer goods obtained by the SEM and 2SLS method are negative but
insignificant at the 5 per cent level (Tables 1 and 2. Appendix A).
They suggest that import substitution might have taken place in
manufactured consumer goods but such import substitution is not
significant. Again the coefficients of Q/Q^in the import demand
function for capital goods being negative and insignificant at the
5 per cent level (Tables 1 and 2, Appendix A) are indicative of
insignificant import substitution in capital goods. The
coefficients of AQt/Q(^ in the import demand function for
intermediate
goods obtained by the SEM and 2SLS method are positive and
insignificant at the 5 per cent level (Tables 1 and 2, Appendix A).
They suggest that im port. - GDP ratio for intermediate goods did
not decline with the growth rate of GDP. But their positivity does
not also rule out the possibility of an increase in the import-GDP
ratio for intermediate goods with an increase in the growth rate of
GDP. Probably two factors are mainly responsible for this. Firstly,
import- GDP ratio for intermediate goods did not decline because of
the self- sufficiency strategy in foodgrain and manufactured
products. Secondly, increased dependence on foreign capital might
have tied Bangladesh to import intermediate goods for the
aid-financed projects, completed or on- going, from the donor
countries and thus made it difficult to reduce imports of
intermediate goods.
Production Structure The production structure in the Bangladesh
economy underwent" some
changes in the process of economic growth. There were some
discontinuous shifts in the sectoral shares in GDP from the primary
to the manufacturing and tertiary sectors. Various factors caused
such shifts but discussion would be limited to the factors included
in the model.
Production Structure and Per Capita Real Income Theoretically we
expect a negative relationship between the primaiy share and per
capita real income. The coefficients of y{ obtained by the SEM,
2SLS
^hine positivity of the coefficients of Qj /Qt in the import
demand function for consumer and capital goods obtained by the 3SJS
method is theoretically unexpected.
^Thc significantly negative coefficients of AQ{/Q{ in the import
demand function for intermediate goods obtained by the 3Sl^S method
is not discussed here because Ahmad (1986, p. 4761) have found no
empirical evidence to import substitution in intermediate
goods.
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Ahmad : Foreign Capital Inflow and Economic Growth 67
and 3SLS methods in the function for the primary share are
positive and significant at the 1 per cent level (Tables 1, 2 and 3
Appendix A). It means that per capita real income had a positive
relationship with the primary share. The main reason for this was
the continuous fall in the absolute expenditure on the primary
products for the Bangladesh economy as a whole with declining trend
of per capita real income. The declining absolute expenditure on
the agricultural products caused the primary share to decline.
A positive relationship is expected between the manufacturing
share and per capita real income. But the coefficients of yt
obtained by the SEM, 2SLS and 3SLS methods in the function for the
manufacturing share are negative and significant at the 5 and 1 per
cent levels (Tables 1, 2 and 3, Appendix A). They suggest a
negative relationship between the manufacturing share and per
capita real income. It implies that the absolute exppenditure on
the manufactured products increased in spite of the declining per
capita real income for the economy. This was probably due to the
greater increase in the absolute expenditure of the upper income
groups offsetting the smaller decrease in the absolute expenditure
of the lower income groups on the manufactured products.
Since the per capita real income declined throughout the period
under study, on the basis of theoretical knowledge it is ruled out
as a causative factor for a rise in the tertiary share. Instead,
growth rate of output is used as an independent variable to explain
it. The coefficient of AQj/Qj based on the SEM and 2SLS method are
insignificant at the 5 per cent level while that based on the 3SLS
method is positive and significant at the 1 per cent level (Tables
1, 2 and 3, Appendix A). The 3SLS result suggests that the growth
rate of GDP had a positive impact on the tertiary share. Perhaps
the rise in the tertiary share was partly caused by demand for
increased services associated with the growth of GDP.
Production Structure and Area Cropped, Imports of Capital Goods,
Population, Economic Overheads, and Government Revenue Expenditure
Area cropped had a negative relationship with the primary share
which is
theoretically unexpected and the negative relationship is
significant at the 1 per cent level (Tables 1, 2 and 3, Appendix
A). Increased area cropped caused increased primary production and
increased value added in the primary sector. Since the rates of
change of output in manufacturing, trade and transport services are
highly correlated with the rate of change of output in agriculture
(Islam 1977, p. 139), the increased area cropped enhanced the value
added in the manufacturing and tertiary sectors much faster than in
the primary sector and thus caused the primary share to decline. A
positive relationship is expected between the primary share and
imports
of capital goods as proportions of GDP. On the contrary, we have
obtained a negative relationship between them and the negative
relationship is significant at the 5 and 1 per cent levels (Tables
1, 2 and 3. Appendix A). The negative relationship perhaps was
caused by the fact that an increase of imports of capital goods was
associated with a decrease of production in the primary
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68 The Bangladesh Development Studies
sector due to mechanical breakdown of agricultural machinery and
bad weather or that good harvests accompanied by good weather
conditions even if the capital good imports would have declined.
The coefficients of N with the manufacturing share based on the
SEM, 2SLS
and 3SLS are positive and significant at the 5 and 1 per cent
levels ( Tables 1, 2, and 3, Appendix A). They suggest that
population size was important for expansion of the manufacturing
sector providing wide market to the manufactured products and
economies of scale in their production.
We have the expected positive relationship between the
manufacturing share T and the tertiary share even though the
positive coefficients of Q t /Qt based on the SEM an 4 2SLS method
are insignificant at the 5 per cent level ( Tables 1 and 2,
Appendix A) and that obtained by the 3SLS method is significant at
the 1 per cent level (Table 3, Appendix A ). Thus the positive
relationship suggests that activities of the tertiary sector
particularly economic overtheads. banking and construction, etc.
appear to support the development of the manufac-turing sector.
The coefficients of Gt/Qt in the tertiary share obtained by the
SEM, 2SLS and 3SLS methods have the expected positive sign and are
significant at the 1 per cent level (Tables 1, 2 and 3, Appendix
A). They indicate that govern- ment revenue expenditure increased
the value added in the tertiary sector through direct and indirect
expansion of employment.
Production Structure and Exports The coefficients of Xt/Qt with
the primary share based on the three methods
are positive as expected and that obtained only by the 3SLS
method is significant at the 1 per cent level (Tables 1, 2 and 3.
Appendix A). This implies that exports have expansionary impact on
the primary sector.
The coefficients of Xt/Qt have the unexpected negative signs in
the manufacturing share. Its negative relationships with the
manufacturing share are significant at the 1 per cent level. They
might be caused by the fact that processing of the primary products
increased the value added and share of the manufacturing share but
increased manufactured product were not associated with increased
manufactured exports due to consumption liberalization (Khan 1963,
pp. 208-231) and import substitution strategy of industrial
development (Ahmad 1986. pp. 305-308). We have the expected
positive relationship between the exports as
proportions of GDP and the tertiary share. The positive
relationships based on the three methods are significant at 1 per
cent level (Tables 1, 2 and 3, Appendix A) suggesting that
expansion of exports increased the value added in the tertiary
sector.
Production Structure and Foreign Capital Inflow (i) Piimary
Sector The coefficients of Ft/Q| in the primary share are expected
to be negative
but they are found positive using the SEM 2SLS and 3SLS methods
of
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Ahmad : Foreign Capital Inflow and Economic Growth 69
estimation (Tables 1, 2 and 3, Appendix A). The positive
coefficient obtained by the SEM is insignificant at the 5 per cent
level while that based on the 2SLS method is significant at the 5
per cent level and that based on the 3SLS method is significant at
1 per cent level. This implies that we have obtained a positive
relationship between the primary share and foreign capital inflow
as a proportion of GDP. The justification for this relationship is
given below.
Foreign capital inflow in the primary sector was received in the
form of food assistance, commodity assistance and project
assistance. Food assistance in Bangladesh was used for foodgrain
imports under PL-480 which generated counterpart funds. Some part
of the counterpart funds financed the Rural Works Programme ( RWP)
and Food for Works Programme (FWP). With the implementation of
these programmes, food assistance increased agricultural
productivity, agricultural production and area under crop
production directly through providing irrigation, drainage. Hood
control embankments and indirectly through construction of roads
and employment of rural and landless labourers. It also created
disincentives for farmers to produce. It is very difficult to draw
conclusions about its overall effects on the Bangladesh economy.
Its negative effects would have been much lower had the subsidized
imported foodgrains been distributed to the extremely poor
consumers. The commodity assistance contributed to increasing
productivity and
production in the primary sector through financing the
procurement and distribution of agricultural inputs to farmers.
The project assistance in the agricultural sector was spent on
production undertaken by the Agricultural Directorate, the
Bangladesh Agricultural Development Corporation(BADC), the Forest
Directorate, the Forest Industries Development Corporation (FIDC),
the Fisheries Directorate, Fisheries Development Corporation and
the Livestock Directorate. Projects of these organizations are both
production oriented and research oriented, which directly or
indirectly increased production in the primary sector.
Project assistance was allocated to the rural institutions of
Bangladesh in the post-liberation period. It financed projects
which increased production directly through providing agricultural
inputs, credit and services, and indirectly through extending
physical facilities for research and training, providing training
facilities for farmers, fishermen and weavers.
Relatively a large amount of project assistance was spent on
flood control, irrigation and electricity generation projects of
the Flood Control and Water Resource Development. These projects
through provision of irrigation facilities, protection from flood
damage, improved drainage of waterlogged areas, and rural
electrification facilitated the increased production in the
agricultural sector.
(W Manufacturing Sector We expect the coefficients of Ft/Q( with
the manufacturing share to be
positive but have obtained them with negative sign using the
SEM, 2SLS and 3SLS methods ( Tables 1, 2 -and 3, Appendix A). The
negative relationships between the manufacturing share and foreign
capital inflow as proportions of
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70 The Bangladesh Development Studies
GDP are significant at the 5 per cent and 1 per cent level. They
may be explained as follows.
Foreign capital inflow supported the import substituting
industrialization in Bangladesh. It developed the manufacturing
sector but with an inappropriate technology. It created the
industrial capacity much of which was not utilized,
underutilization being higher in the post -liberation period
compared to the pre-liberation period in spite of higher inflow of
foreign capital. Some industries were over-expanded with foreign
capital inflow but they contribute nothing at the margin to the
manufacturing output due to negative marginal productivity of
labour and capital in those industries (Soligo and Stern 1965).
Furthermore, the productivity of foreign capital was apparently
greater for the primary and tertiary soctor than the manufacturing
sector. There was foreign private investment in the manufacturing
sector but the reported value added from the industries set up with
foreign private capital was very small or negative because of
artificially high accounting prices of their imports from their
parent companies abroad. Thus the foreign capital inflow had both
the positive and negative effects on the manufacturing sector.
Probably its negative effects were larger than its positive effects
causing the negative relation.
(Hi) Tertiary Sector The coefficients of Ft/Qt with the tertiary
share have the expected positive
sign and the coefficients based on the SEM, 2SLS and 3SLS
methods are significant at the 5 per cent, 1 per cent and 10 per
cent level, respectively (Tables 1, 2 and 3, Appendix A). They
suggest that foreign capital inflow had significantly positive
impact on the tertiary share. This positive relationship may be
explained in this way. Aid financed projects in the tertiary sector
employed local people and thus
directly increased its value added. Some of these projects
helped production and distribution directly and sometimes with some
time lags. Some other projects facilitated economic growth through
the generation of external economics. Some portion of the commodity
assistance was also used to finance maintenance imports for this
sector. Some of the aid financed projects in the agricultural and
manufacturing sectors involved construction works which directly
increased the value added in the construction sector. Construction
activities under the RWP and FWP in the rural sector increased the
value added in this sector. Thus foreign capital inflow as a
proportion of GDP was found to have a significantly positive effect
on the tertiary share.
V. CONCLUSION
Studies on the two-gap theory hypothesize that foreign capital
inflow can promote economic growth in LDCs by relieving constraints
to growth. Like the empirical studies of Cohen ( 198), Papanek (
1973 ), Voivodas ( 1974) , Stoneman (1975), and Gupta ( 1975), our
study support the above hypothesis opposing Griffin and Enos (1970)
who have found a negative relationship between growth of output and
foreign capital inflow as proportion of GDP.
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Ahmad : Foreign Capital Inflow and Economic Growth 71
Rahman (1967) and Griffin (1970) have propounded the
"Psychological Hypothesis" that an increase in foreign capital
inflow causes a relaxation of the government's domestic saving
efforts and thus reduce domestic saving. Since the domestic saving
was the dominant constraint to the economic growth of Bangladesh
and we have found a non-positive relationship between the domestic
saving and foreign capital inflow, our study suggests that
Bangladesh government might have relaxed its saving efforts. Thus
it tends to support the "Psychological hypothesis" as Rahman (
1968), Griffin (1970), Ahmed (1971), Weisskopf (1972), Papanek
(1973), and Gupta (1975) have corroborated it.
Since foreign capital inflow was found to have a positive effect
on all categories of imports in Bangladesh, our study lends support
to the hypothesis of Massel, et al. (1972) and Voivodas (1974) that
there is positive relationship between imports and foreign capital
inflow.
Like Chenery and Syrquin (1975) we have found that foreign
capital inflow caused a change in the production structure of the
Bangladesh economy. They have found that the primaiy share declines
and the manufacturing share rises with an inflow of foreign capital
in LDCs. We have obtained a positive relationship between the
primary share and foreign capital inflow as proportions of GDP, and
a negative relationship between the manufacturing share and foreign
capital inflow as proportions of GDP. Thus, our findings are
opposite to those of Cheneiy and Syrquin with respect to the
effects of foreign capital of Chenery and Syrquin with respect to
the effects of foreign capital inflow on the primary and
manufacturing shares. However, they and we have obtained the
similar finding of a positive relationship between the tertiary
share and foreign capital inflow as proportions of GDP.
Foreign capital inflow had a positive contribution to the growth
of GDP but made the government of Bangladesh to relax the saving
efforts. There were some import substitution in all categoreis of
imports but the extent of import substitution was not adequate
enough to reduce overall import demand. There were shifts in the
sectoral shares of GDP but such shifts were discontinuous. Thus
there were structural changes in the Bangladesh economy during the
last two decades but such changes were not adequate to ensure
self-sustained growth reducing its dependence on foreign capital
inflow.
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Ahmad : Foreign Capital Inflow and Economic Growth 73
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74 The Bangladesh Development Studies
Appendix A TABLE 1
ESTIMATION OP THE MODEL FOR BANGLADESH BY THE SEM :
1960/61-1979/80
(t-ratios in parentheses)
1. Growth Function : OLS
AQl Si R Mt 9 -r^ = 0.18-r^ + 0.1877- + 0.18 + -- R2= 9 -
0.18d.f.l6
yt t n. l
(2.01)c (2.01)c (2.01)c I)W= 1.90
2. Saving Function : FOAM
^- + 0.1 0-O.6I) - 0.05-^1 1.23 ll +1.14 -=f R2 = 0.76 d.f. 12 H
H wt Wl
(0.47) (-0.91) (-0.49) (-3.09) (1.21) DW=1.24
3. (i) Import Function lor Consumer Goods : FOAM
< ct or 0 < ,, x, = 0.23r^-- 0.32 0.09 0.82 +0.23 7^- ,,
+0.26-^ x, 9t 9t q 9t 9t a 9
(3.34)a (- 2.93)b (-0.80) (- 2.71)b (1.31) (2.02)c
R2=0.58 d. f. 11
OW= 2.49 (ii) Import Function for Intermediate Goods : OLS
Mt AQ, Ft X , o - =- 0.02D+ 0.02 7=^+0.2277-+ 0.5677- , R2 o =
0.78 d.i. 13
Q t ^t t ^t (- 2.91)b (1.21) (3.69)a (7.59)a D'V=1.98
(iii) Import Function lor Capital Goods : FOAM
t I t Ir X - t 0.04D + 0.06 ^ ^ I 0.07 1- 0.46 - **
- O.20 -^- X
^ R2 = 0.83
9t ^ 9t ** ^
(4.31)a (1.83)c (-0.70) (5.79)a (-1.45) DW=1.19 ___
7V'K/JB i (Conici.)
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Ahmad : Foreign Capital Injlow and Economic Growth 75
TABLE 1 (Conici.)
4. (i) Function for Primary Share : OLS
- = 0.92+0.73 log y -1.35 log '' -2.20 - + 0.66-^- + 0.05r^-
Qt
9l Qi a
(1.53) (3.62)a (- 3.92)a (- 2.60)b (1.28) (0.13)
R2 =0.77 d.f. 11
I)W = 1 .67
(ii) Function for Manufacturing Share : FOAM
= 0.08+0. 121) -0.22 log y + 0.28 log Nt+0.17 0.39^-1.06^. Qt
9t
^ ^
(0.60) (5.38)a (- 2.85)b (2.69)b (1.44) (- 3.01)b (- 6.22)a
R2 = 0.86 d.f. 10
DW=2.81
(iii) Function for Tertiary Share : FOAM
9( AQ, Ci, F X, =0.21 - 0.070 - 0.05-~- + 1.36 r- + 0.45 77- +
1.40 -~- Q H H 9t 9(
(12.25)a (- 3.38)a (-1.33) (7.99)a (2.73)b (4.24)a
R2 = 0.92 d.f. 11
DVV= 2.08
Two-tailed t-test is performed a = significant at 1 per cent
level b = significant at 5 per cent level e significant at 10 per
cent level.
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76 The Bangladesh Development Studies
TABLE 2
ESTIMATION OP THE MODEL FOR BANGLADESH BY THE 2SLS METHOD:
1960/61-1979/80
(t- ratios in parentheses)
1. Growth Function .v,k
-r-i- - 0.18 rf --0.18 ri- +0.18 9t 01 l. g
(2.07)b (2.07)b (2.07)b
2. Saving Function
S( AQt Ft Xi 77-= 0.10 - 0.6D - 0.06-^ 1.21 ^- +1.10-^- yt ty H
H
(0.85) (- 0.90) (- 0.54) (- 2.94)a (1.13)
3. Import Function for Consumer Goods
Mt C. 0[ 0t Mt p. v - -= 0.23 --- 0.31 0.09 0.81 +0.23 -^ gi
+0.26-^-
q l Qt o, . o, gi !
(3.24)a (- 2.83)a (-0.78) (-2 06)'1 (1.29) (2.00)
(ii) Import Function lor Intermediate Goods
i AQ F X - i -- 0.02) + 0.02 -1+ 0.22 ^- + 0.57 -r^- *^t O ^t ^t
*^t wt (- 3.36)a (0.99) (4.19)a (8.70)a
(iii) Import Function for Capital Goods
Mt I. 9t rt Xt . 0.04D + 0.06 ~ 0.07 + 0.45 -^ 0.20 rf q Qt 9(
ft Qt
(4.19)a (1.77)r (-0.64) (5.60)a (-1.41) . .
(Conta.)
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Ahmad : Foreign Capital In/low and Economic Growth 77
TABLE 2 (Contei. )
4. Function for Primary Share
of M iv x. =0.37 - 0.98 log yt - 1.39 log pt - 5.07 +
1.60^-+0.77 r- q 9t Wl Wl
(0.50) (3.80)a (- 3.51)a (- 3.16)a (2.21)b (1.44)
(ii) Function for Manufacturing Share
or - = 0.09 + 0. 121) - 0.22 logyL . . +0.28 log - N( + 0. 18
03HQ yt 105 o yt Qt
. . - ^
yt o yt
(0.65) (5.28)a (- 2.83)a (2.61)a (1.44) (- 2.95)a (- 6.06)a
(iii) Function for Tertiary Share
9t. jq{ g, '' x, - =0.21 - 0.071) - 0.05-7:7-+ 1.37 r~+ 0.44 7^+
1.40 rf Q 9t t 9t Q[ wt
(12.06)a I- 3.33)a (-1.30) (7.90)a (2.66)a (4. 18)a
In 2SlvS method of estimation, t-statistics follow an asymptotic
standard normal distribution.
a = significant at 1 per cent level b = significant at 5 per
cent level c = significan I at 10 per cent level.
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78 The Bangladesh Development Studies
TABLE 3
ESTIMATION OF THE MODEL FOR BANGLADESH BY THE 3SLS METHOD:
1960/61-1979/80
(I -ratios in parentheses)
1. Growth Function
Qt St F( Mt Qt tm0A5i St +0I5qT F( +ai5T wt
(1.79)c (1.79)c (1.79)c
2. Saving Function
^+0.14 - 0.150 - 0.27^--- 0.82 rj- + 0.93 rr*- wt wt yt i
(2.85)a (1.77)b (- 7.85)a (-1.41) (0.84)
3. (i) Import. Function for Consumer Goods
=0.36 -^ 0.60 +0.60 1.5) -f 0. 16 --+0.4O -
Qt 9|
Qt Q{ Q{ 9t 9l
(6.65)a ( 7.51)a (3.2
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Ahmad : Foreign Capital Inflow and Economic Growth 79
TABLE 3 (Con Id.)
4. (i) Function for Primary Share
Of Mf p x =0.23+ 1.23 log yt- 1.81 log p( - 25.24 +7.53 -+7.02^.
(0.64) (3.27)a (- 3.40)a (-14.08)" (3.93)a (7.37)a
(ii) Function for Manu laetu ring Share
Q? Ft xt - = 0.12 +0.1 ID -0.20 logyt " + 0.20 log Nt +0.28 a25^
*
L12?^ t Q{ "
9t * t (2.26)b (8.32)a (- 4.29)a (4.45)a (5.31) a (- 3.30)a (-
7.83)a
(iii) Function for Tertiary Share
9t AQt Gt Ft X. =0.26 - 0.09D +0.11 "0^+0.81 ^ -29 "+ 138 ~
wt
(18.18)a(-4.39)a (4.95)a (6.43)a (1.86)c (4.89)a
In 3SLS method of estimation, t-statistics follow an asymptotic
standard normal distribution.
a = significant at 1 per ceni level b = significant at 5 per
cent level c = significant at 10 per cent level.
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Issue Table of ContentsThe Bangladesh Development Studies, Vol.
18, No. 1 (March 1990), pp. 1-118, i-ixFront MatterThe
Macroeconomics of Policy Reform: Experiments with a CGE Model of
Bangladesh [pp. 1-35]On Cost-Benefit Analysis of Weaving by
Handlooms, Powerlooms and Mills in Bangladesh, 1986/87 [pp.
37-54]Foreign Capital Inflow and Economic Growth: A Two Gap Model
for the Bangladesh Economy [pp. 55-79]Notes and CommentsSome
Aspects of Inflation in Bangladesh [pp. 81-92]A Note on the Income
Velocity of Circulation of Money in Bangladesh [pp. 93-105]
Book ReviewReview: untitled [pp. 107-115]
Back Matter