Investigation on the Effects of External Shocks on Bangladesh's Economy: An Application of the Gvar Modelling Approach

Abstract

This paper uses the global vector autoregressive (GVAR) modelling approach to study (1) the effects of negative output shocks on Bangladesh's following trading partners on Bangladesh's economy: the United States, China, Eurozone, India and Saudi Arabia (2) positive global oil price shocks. To represent Bangladesh's macroeconomics, the GVAR model contains four key macroeconomic variables as endogenous variables. They are (1) real gross domestic product (GDP), (2) real exchange rate, (3) short-term interest rates, and (4) inflation. The specified GVAR model is estimated using quarterly data from 32 countries/regions from 1993Q4 to 2016Q4. The findings of this paper are consistent with theoretical predictions that external shocks can and will be transmitted to an open economy operating under a fixed or managed floating exchange rate system. For example, quantitatively, if the real output of Bangladesh's trading partners' falls by 1%, its output will fall by 0.39%, while the inflation rate of Bangladesh's trading partners' rises by 1%, and Bangladesh's inflation rate will increase by 1.38%. Although the negative output shock of the US economy will not significantly affect the Bangladeshi economy, the negative output shock of the Chinese economy will have a negative and significant effect on the Bangladeshi economy. The negative output shock on the US economy has caused the real exchange rate of Bangladesh's currency to appreciate and raised its short-term interest rate, although it is not statistically significant. Contrarily, a negative output shock to China or other economies devalues the real exchange rate of the Bangladeshi currency, although it is not statistically significant. However, Bangladesh's interest rates have not responded to negative output shocks from its trading partners (except the United States and Saudi Arabia), and they are not statistically significant. One policy implication of Bangladesh's inflation being overly sensitive to external inflation shocks is that Bangladesh can and should make its currency exchange rate more flexible to protect its economy from external price shocks. Unexpectedly, the external oil price shock did not seem to have a significant impact on the Bangladeshi economy. One explanation is that the impact of foreign inflation on Bangladesh's economy may have reflected the impact of oil prices.