A Review of Banik’s The Indian Economy: A Macroeconomic Perspective

Undergraduate economics education in India relies heavily on American textbooks, especially to teach Microeconomics and Macroeconomics. So it was a welcome change to see Nilanjan Banik’s The Indian Economy: A Macroeconomic Perspective published in 2015 by Sage Publishers. It is intended to be a Macroeconomics textbook for Indian students. As Banik writes in the Preface, ‘the available standard macroeconomic textbooks have limited information about how macroeconomics works for India.’ And therefore, ‘[t]his book is for anyone who wants to clear their concepts on Indian macroeconomy.’ This blog post critically reviews (only) Chapter 1 of this book titled ‘Introducing Macroeconomics’.

Banik starts Chapter 1 with an explanation of why macroeconomics – output, employment and inflation levels – is of significance to a ‘common man’. Here, basic macroeconomic concepts and their measurement are explained. Some discussion on the evolution of growth theories is also present. Economic prosperity of common person, according to Banik, is ‘encapsulated in a higher growth rate of GDP and lower inflation and unemployment rate, since these are the factors which directly or indirectly affect his/her well-being.’ But, we must also recognise that an individual’s employment and India’s overall unemployment rate are interdependent variables, and consequently we cannot draw a simple causal line of ‘prosperity’ running from overall employment rate to an individual’s well-being. [By interdependent, I mean that the aggregate employment rate is a summation of individual employments. Not only this, but also that the magnitude and trend of aggregate employment rate often impacts the rate of investment and therefore individual employment.] And, later, on p. 19, he draws a totally reverse causal line: ‘A summation of individual well-being gives us a sense about how an economy is doing.’

Output and employment levels are determined by factors affecting aggregate supply and demand. ‘Economy-wide demand and supply conditions are aggregation of all individual market conditions.’ Is this correct? Market supply and demand curves are an aggregating of individual market supply and demand curves. But, is it legitimate to extend this argument to aggregate supply and demand? Or, is Banik here making a microfoundations argument? A macroeconomic equilibrium is characterised by the equality between planned saving and investment and therefore of aggregate supply and demand. Banik is committing the fallacy of composition in the above quoted sentence wherein aggregate demand condition is seen as an aggregation of all the individual market demand conditions.

Subsequently, Banik starts the discussion on economic growth by clarifying to the reader that the growth rate of an economy refers to the growth rate of real gross domestic product (GDP) of that economy. ‘Supply of output is determined by the availability of factor endowments such as labour, capital, organization, and technology in the economy.’ Aggregate demand is made up of consumption, investment, government and foreign demand. The full-employment level of output, as in neoclassical economics, according to Banik, is determined by supply-side factors. Therefore, it follows that supply-side policies are to be undertaken in order to increase the full-employment level of output. Hence, he writes:

‘However, any policy measure to increase the supply of output requires time. … So managing supply-side components is not that effective in the short run; however, in the long run, components such as investment in education, health-care, and physical infrastructure will have an influence over the availability of future supply of output.’ (p. 6)

What is the role for demand-side policies in this growth framework? They are employed only to take care of ‘fluctuations’ for they have no role to play in determining the full-employment level of output. This is validated by the following excerpt from Banik.

‘Demand management policies would not have been important if there was no fluctuation in demand, taking the output away from the full employment level of output.’ (p. 7)

It suffices here to note that this is a contested assertion with the contestation emerging from the research on demand-led growth.

Among historians of economic thought and economists with a historical understanding, classical economists refer to Adam Smith, David Ricardo, Robert Malthus and Karl Marx, who, while distinguishing himself from their works also employed their framework – the surplus approach to value and distribution. However, in textbooks of Macroeconomics, pre-Keynesian economics is commonly, although incorrectly, classified as classical economics; Keynes is also responsible for this confusion. Banik has a very different understanding of classical economics or as he writes, the ‘classical school of economics’. For him, it comprises ‘particularly, the Austrian school of economists led by Hayek, Robbins, and Schumpeter’ (p. 7).

On Keynes’s principle of effective demand, Banik has the following to say. ‘

Keynes tried to explain the occurrence of an event like the Great Depression through his notion of effective demand. Effective demand is the quantity of goods and services that consumers buy at the current market price. According to Keynes, economic agents behave like animals – all of a sudden becoming optimistic or pessimistic about the future. When on average, economic agents become pessimistic about the future, then consumers start spending less money, firms cut down their production, and the economy enters into recession. In Keynesian model, the emphasis is on demand-side factors.’ (p. 7)

The principle of effective demand states that aggregate activity levels are determined by aggregate demand, and that planned saving adapts to planned investment. This principle was advanced in opposition to the neoclassical Say’s law which states that supply creates its own demand. Moreover, this principle works even without having recourse to animal spirits.

Following this, Banik presents a brief overview of Samuelson’s neoclassical synthesis, Lucas’s critique, real business cycle theory and new classical approach (pp. 10-11); and, he categorises the following economists within the ‘new Keynesian group’: ‘Gregory Mankiw, Lawrence Summers, Olivier Blanchard, Edmund Phelps, and John Taylor’ (p. 12). Such a classification of economists along with the overview of different macroeconomic schools is of much value to the student readers.

After carrying out a short empirical discussion on India’s macroeconomy and empirical definitions such as consumer durables, service exports, etc, Banik makes a fallacious statement regarding the relationship between saving (S) and investment (I).

‘…in a closed economy framework … one would expect domestic savings to be the only source of investment. Accordingly, what is saved is invested and hence investment is expected to be equal to savings. In the present context, however, there is a divergence between investment and savings components of GDP. This divergence is on account of the fact that we are considering an open economy framework where we allow for foreign transactions. Typically, the more open is the economy, the more is the extent of this divergence.’ (p. 17).

In a two-sector economy (with firms and households), the accounting identity S=I holds. But, what is the explanation or theory behind this? It is the principle of effective demand: planned saving adapts to planned investment (via changes in activity levels). The mainstream neoclassical view is that planned investment adapts to planned saving (via changes in a sufficiently sensitive rate of interest). In a three-sector economy (with firms, households and a government), the accounting identity becomes: S+T = I+G, where T is taxes and G is government expenditure. And, in a four-sector economy (with firms, households, a government and the foreign sector), the accounting identity is: S+T+M = I+G+X, where M is imports and X is exports. In other words, the above 3 identities reaffirm the condition for macroeconomic equilibrium: leakages must equal injections. Thus, in equilibrium, there can be no divergence between saving and investment in a two-sector economy and in general, in equilibrium, leakages equal injections. Banik appears to be confusing macroeconomic theory with accounting identities, and disequilibrium with equilibrium positions. The above statement of Banik is therefore conceptually incorrect.

Next, he presents a commentary on growth economics, with a focus on the Harrod-Domar and Solow growth models.

‘One of the earlier works in the area of supply-side economics was independently undertaken by two economists – Roy Harrod in 1939 and Evsey Domar in 1946. The relevance of the Harrod-Domar model lies in its ability to give a dynamic flavour to the Keynesian model. The Keynesian model is a static model putting emphasis on aggregate demand and its effect on the output gap in the short run.’ (p. 21)

In the mushrooming, although at a moderate pace, research on demand-led growth, the growth model of Harrod is a seen as an early contribution to demand-led growth and not supply-side growth. It is not clear why Banik places Harrod’s contribution under supply-side economics. He goes on to point out limitations of Harrod’s model.

‘Another limitation of the model is that it assumes that labour and capital and used in equal proportions (equal prices for labour and capital).’ (p. 22).

Here, he makes yet another incorrect statement because Harrod assumed that labour and capital are used in constant not equal proportions. With this glaring error, one cannot help but wonder whether this macroeconomics textbook went through any serious internal or external reviewing. Banik then goes on to discuss the Solow model and undertakes a very brief survey of the endogenous growth models of Paul Romer, discusses the work of Robert Hall and Charles Jones on social infrastructure, and Robert Fogel’s study of the positive association between health and economic growth. Next, the author moves on to issues involved in the measurement of GDP, and in this context clarifies the meaning of operating surplus and mixed incomes.

To conclude, whilst Banik’s macroeconomics book for Indian students contains serious conceptual errors, the design of the structure of chapter one (and the others) deserves some merit. There is indeed ample scope for improvement and enlargement of the contents. Yet, it is deeply disappointing to come across the errors, such as the ones mentioned in the preceding paragraphs, in a book such as this which is stated to be an advance over existing (foreign) macroeconomics textbooks.