Course No: E501
Course Name: Managerial Economics
Efficiency of Monetary policy in containing inflation
Prof. Mohammed Farashuddin PhD
Course Instructor, Managerial Economics
Momotaz Mahin Khan
IBA, University of Dhaka
Date of Submission: Dec 08, 2012
What is monetary policy?
Monetary policy is the process by which the government, central bank, or monetary authority of
a country controls (i) the supply of money, (ii) availability of money, and (iii) cost of money or
rate of interest to attain a set of objectives oriented towards the growth and stability of the
Latest Monetary policy of Bangladesh:
Bangladesh Bank announced its monetary policy statement (MPS) for the second half of the
current fiscal year. Explicitly or implicitly, the objectives that the MPS seeks to accomplish are:
* Maintaining inflation at moderate levels (current inflation rate: 7.22% as of October 2012)
* Limiting depletion of foreign exchange reserves and establishing external sector equilibrium
* Supporting GDP growth of 6.5 - 7.0%.
The role of money
Money was invented because it solved many of the severe limitations of bartering. With money
a person can buy from and sell to different people much more easily. Money also allows
production and consumption to more easily happen at different times. It gives people the ability
to save money and spend it later.
However, for money to work well it must be a reliable standard of value and, money needs to be
an effective store of value.
What is price stability?
Price stability exists when prices overall are stable (ie, money is an effective store of value). This
does not mean that prices are frozen, but rather that taken on the whole they are stable. In an
environment of price stability, you would expect some prices to be rising but others to be falling.
What causes price stability, inflation and deflation?
The rate of inflation tends to increase when the overall demand for goods and services exceeds
the economy's capacity to sustainably supply goods and services. Likewise, when productive
capacity is greater than demand, the rate of inflation tends to decrease, and, if the excess capacity
persists, deflation can occur.
By "demand" we mean the desire for goods and services that is supported by the means to
purchase those goods and services.
By "the economy's capacity to sustainably supply those goods and services" we mean the level of
production that can be sustained without shortages occurring.
Thus, throughout the economy, if factories are working flat out to meet demand, inflationary
pressure may emerge. Factory staff will work longer hours, which may require overtime
payments, thereby forcing firms to put up their prices.
Conversely, if factories are producing more goods than they can sell, then to get rid of the stock
that is building up they may have to reduce their prices. If enough do this the rate of inflation
will start to fall.
Figure 1: The inflation rate of Bangladesh – Jan 20011-Jul 2012
How do we measure inflation and deflation?
Inflation refers to a general rise in prices measured against a standard level of purchasing power.
Previously the term was used to refer to an increase in the money supply, which is now referred
to as expansionary monetary policy or monetary inflation. Inflation is measured by comparing
two sets of goods at two points in time, and computing the increase in cost not reflected by an
increase in quality. There are, therefore, many measures of inflation depending on the specific
circumstances. The most well known are the CPI which measures consumer prices, and the GDP
deflator, which measures inflation in the whole of the domestic economy. The prevailing view in
mainstream economics is that inflation is caused by the interaction of the supply of money with
output and interest rates.
Figure 2: The CPI of Bangladesh – Jan 2011-Jul 2012
Why is price stability better than inflation or deflation?
Price stability helps create an environment where economic growth may occur more easily. It
does this by enabling money to work as the means by which people and businesses transact and
contract with one another. When inflation is high, firms and businesses face uncertainty about
the future, and this changes the way in which they behave.
Another way in which inflation impacts on the economic system is by clouding relative price
signals. When inflation is high it also tends to be very volatile.
When inflation is volatile it becomes less clear whether a price change reflects a change in the
relative demand or supply of that individual good or service, or whether it is just part of a
generalized movement in prices across the board. As mentioned earlier, relative price changes
provide useful information for producers when deciding whether they should produce more or
less of a particular good or service.
As you can see, the uncertainty caused by inflation hinders economic growth. In the extreme
case, that of hyperinflation, price signals become so confused and financial contracts based on
money are so unreliable that people may stop participating in the market economy altogether.
On the other hand, if prices are stable, people and firms are able to make their investment, saving
and consumption decisions without having to worry about protecting themselves from the effects
of inflation. This enables resources to be allocated more effectively.
What about deflation?
Deflation causes many of the same problems as high and variable inflation. It also creates a
powerful incentive not to invest (and thus increase productive capacity). If average prices are
falling then the value of money is rising. In that circumstance, possibly the best investment will
be to hold money. As more and more people hold money, a deep deflationary cycle can set it.
Historically, the run-away effects of deflation have been devastating. There was a strong element
of this in the Great Depression of the 1930s. More recently in Japan, there has been concern
about the way in which falling consumer prices are undermining demand in that economy.
How does the Central Bank control inflation and avoid deflation?
As mentioned above, the balance between the overall demand for goods and services and the
economy's capacity to sustainably supply them determines inflation. In the jargon of economists,
the difference between demand and the economy's capacity to supply is known as the output gap.
Monetary policy can't affect the economy's capacity to supply. However, monetary policy can
stimulate or dampen demand. This is done by adjusting short-term interest rates. The Central
Bank tries to influence the output gap so the amount of pressure on resources causes inflation to
remain within the one to three percent inflation band.
What is the output gap?
The output gap is the difference between demand and the economy's capacity to supply. This is
the difference between the ‘actual' level of output (GDP) and the economy's ‘potential' level of
output (potential GDP).
If the economy is running above capacity (GDP > potential GDP) the output gap is positive.
Conversely, if the economy is running below its full capacity (GDP < potential GDP) the output
gap will be negative.
How does the short-term interest rates affect inflation?
Higher interest rates put less borrowing power in the hands of consumers (business).Thus
consumers spend less; the demand slows down, thereby controlling inflation and vice versa.
The benchmark interest rate in Bangladesh was last recorded at 7.75 percent. Interest Rate in
Bangladesh is reported by the Bangladesh Bank. Historically, from 2008 until 2012, Bangladesh
Interest Rate averaged 7.2 Percent reaching an all time high of 8.8 Percent in February of 2009
and a record low of 4.5 Percent in July of 2010. In Bangladesh, interest rates decisions are taken
by the Bangladesh Bank. The Bangladesh Bank controls two policy interest rates: the repo rate
(repurchase rate), which it uses to inject money into the banking system, and the reverse repo
rate. This page includes a chart with historical data for Bangladesh Interest Rate.
Figure 3: Bangladesh Interest rate – Jan 2011-Jul 2012
How does the exchange rate affect inflation?
Movements in the exchange rate can have both a direct and indirect effect on inflation. Changes
in the exchange rate directly affect the prices of the things that one imports, if the value of the
currency (taka) depreciates then the price of imported goods and services will increase. And
therefore contribute to inflation.
Exchange rate movements also have an indirect effect on inflation. If the currency (taka)
depreciates then the products of that country become relatively cheaper for foreigners and
demand for the exports will increase. The associated increase in demand for the country’s goods
and services can contribute to spending exceeding potential output, causing inflationary pressure.
How does monetary policy affect the exchange rate?
Often, but not always, an increase in domestic interest rates will cause the exchange rate to also
rise or appreciate. If interest rates are relatively higher in one economy (suppose Bangladesh)
than in other economies, overseas investors will be more likely to invest in as they receive a
relatively larger return for their money. However, before overseas investors can invest in
Bangladesh exchange their foreign currency into Bangladesh taka. This increase in demand for
Bangladesh taka will cause the Bangladesh taka to appreciate.
Many other factors also affect the exchange rate. One such factor will be changes in the world
market for the goods and services that Bangladesh exports. Also, financial market expectations
of future developments can have an important influence on the exchange rate. All these factors
make forecasting exchange rates movements notoriously difficult.
Efficiency of Monetary policy in containing Inflation (Bangladesh perspective)
The monetary policy suffers from inherent limitations, particularly in a country like Bangladesh
characterized by many imperfections in money and capital markets and a high degree of importdependence.
The effectiveness of monetary policy is predicated on (i) clear articulation of the objectives (ii)
the impact of target variable (s) chosen on the objectives, and (iii) instruments available at the
disposal of the central bank to influence the target variables.
Objectives and target variable
The objectives of the present MPS have been laid down as: "BB's monetary policies will
continue pursuing the dual objectives of maintaining price stability and supporting faster
economic growth and poverty reduction. Continuous watch will be maintained to locate and
neutralize likely inflationary pressures from the growth supportive monetary and credit policies,
which, to the extent feasible, will be targeted to selected priority productive sectors. Deepening
of financial inclusion of agriculture, SMEs, renewable energy and ecological footprint
minimizing technology sectors will continue to remain the key areas of policy supports with
refinancing lines." Leaving aside the rhetoric of financial inclusion and poverty alleviation, I
would like to focus on the two macroeconomic objectives -- growth and inflation.
In the prevailing milieu of macroeconomic management, central banks have become severely
constrained in the choice target variables. Administered interest rates and directed credit
allocation are no longer in fashion, though Bangladesh Bank resorts to these practices on a
limited scale, sometimes informally. This situation implies that practically the only target
variable Bangladesh Bank can seek to influence is the broad money supply.
It is evident that "the interest rate structure is an outcome of complex interplays of conflicting
interests of savers and entrepreneurs in the credit and capital markets. Regulatory interventions
on interest rates are best limited to those justifiable on consumer protection grounds;
interventions beyond those limits will impair the effectiveness of monetary policies, obstructing
normal transmission channels of monetary policies"
The normal transmission channel: Does it work in Bangladesh?
The normal transmission channel of monetary policy is that an increase in money supply would
cause a reduction in interest rate; this would lead to increase in investment and thereby higher
aggregate demand and higher GDP. Along the way there may be some increase in inflation,
depending on constraints on the supply side.
Conversely, a reduction in money supply would cause an increase in interest rate, fall in
investment and aggregate demand leading to lower inflation and possibly lower GDP. In the
context of Bangladesh, policy stance factoring reduced money supply and thereby higher interest
is out of the question as acceleration of GDP growth remains the overriding development
At any rate, the first link in the above-mentioned chain of causation runs from money supply to
interest rate. The experience in Bangladesh shows that this link does not work effectively. An
examination of data from FY 02 to FY 10 shows that during these nine years movements in
interest rate (lending rate) were in the predicted direction in only three years. In the other six
years, higher growth of broad money relative to the preceding year was accompanied by higher
interest or a lower growth of money supply was accompanied by lower interest.
The reason for the breakdown of the link between money supply and interest rate most likely is
that the financial system of Bangladesh does not operate under the principles of competition. The
banks, particularly the private ones, collusively determine the lending rate with little regard for
money supply conditions. It follows that monetary policy cannot be expected to be an effective
tool for accelerating growth.
In the above scenario, it is no wonder that money supply has no discernible impact on inflation
either. Data for ten years (FY01-FY10) show that, year to year variations in growth of money
supply notwithstanding, inflation in every year was higher than in the preceding year excepting
in FY 09 when inflation was lower than in FY 08. This was because the rate in FY 08 was
unusually high in consequence of global inflation resulting from dramatic increase in the prices
of food, fuel, fertilizer and many other raw materials and intermediate goods.
In an open, import-dependent economy like Bangladesh, domestic prices are largely determined
by international prices. Hence, monetary policy is bound to be ineffective in containing inflation.
Instruments to influence target variables
The last point to attack of the effectiveness of monetary policy is that the instruments available at
the disposal of the central bank, namely variations in cash reserve/statutory liquidity
requirements and operations in treasury bonds, cannot exert significant influence on the target
variable, namely, money supply.
The principal explanation lies in the fact that banks in Bangladesh typically maintain large
excess liquidity amounting to nearly Tk.31,000 crores as of end-May 2010. In this situation, it
would be futile to expand money supply through reduction in cash reserve requirement/statutory
liquidity requirement or treasury bond operations because, if demand conditions permitted, the
banks would prefer to earn higher income by expanding credit anyway instead of maintaining
Similarly, reasonable increases in cash reserve requirement/statutory liquidity requirement or
Treasury bond operations would not be of much help in inducing banks to restrain credit since
they can fall back upon excess liquidity.
It is established that (in general):
Price stability occurs when overall prices are not rapidly increasing (high price inflation) or
In an economy where prices are relatively stable, money retains its value and this helps to create
an environment where economic growth may occur more easily
The rate of inflation tends to increase when the overall demand for goods and services exceeds
the economy's capacity to supply goods and services (or the output gap is positive).
Let's imagine that inflation is too high. In this scenario, interest rates will need to be increased to
lower the inflation rate.
When the Central Bank increases the Official Cash Rate, commercial banks will earn a higher
return from overnight cash deposits, and pay a higher overnight interest rate when borrowing
from the Bank. As a result, the short-term interest rate used between commercial banks will
increase. The will put upward pressure on short term interest rates banks offer to customers, and
will also push rates higher through the wider financial system and to longer-term interest rates.
Both the cost of borrowing and the benefit of saving increase for the broader economy.
Borrowers tend to reduce their spending as the cost of credit increases, and savers have an
incentive to save more, because their interest returns are higher. These effects both lead to less
spending in the economy, pushing the output gap lower and subsequently inflationary pressures
Monetary policy also has a psychological effect. When the Official Cash Rate is increased it is a
signal to everyone that the Central Bank is taking measures to reduce the rate of inflation. If
people believe the Central Bank is committed to low inflation and that the Bank will be
successful, they incorporate a lower future rate of inflation into the contracts they enter into, such
as in wage contracts. In this way, expectations of lower inflation can assist in lowering the actual
inflation rate in the future. In effect, the expectation of lower inflation is self-fulfilling.
Conversely, if people think that inflation will rise, or remain high, that can make it more difficult
for monetary policy to reduce inflation.
Today people believe the Central Bank is serious about containing inflationary pressure.
However, when the Bank was first mandated to deliver and maintain low inflation, many were
skeptical. This meant that the Bank had to maintain much higher real interest rates to get and
keep inflation down compared to today.
In conclusion (Bangladesh perspective), the above analysis clearly points to the ineffectiveness
of monetary policy in accelerating growth or containing inflation. This does not mean monetary
policy has no role in the country's development process.