Professional Documents
Culture Documents
Monetary Policy System
Monetary Policy System
Monetary Policy System
Monetary policy of
Bangladesh
Submitted to
Masuda
Yasmeen
Professor
Department of Economics
University of Dhaka.
Course
no:404
Submitted by
Khalid Imran
Roll-054
4th Year (2nd batch),8th Semester,
session: 2007-08
Department of Economics
University of Dhaka
Date of submission-02/05/2012
Part-1
Basics on Monetary Policy
1.1 Introduction..1
1.1.1 An Overview......1
1.1.2 Definition of Monetary Policy & Fiscal policy....2
1.2 Objectives of monetary policy.2
1.3 Theory Behind Monetary Policy ....2
1.4 Types of monetary policy.....5
1.5 Time and uncertainty ..6
1.5.1 Monetary policy faces two types of uncertainty.6
1.5.2 Dealing with uncertainty ..8
Part-2:
The Money Supply Procedure of Bangladesh Bank
2.1 Background..11
2.2 The Central Banks Balance Sheet.....11
2.2.1The Monetary Base.....13
2.2.2 Money Stock Pyramid .13
2.2.3 Narrow Money (M1)..13
2.2.4 Quasi Money (QM) ...14
2.2.5 Broad Money (M2) ..14
Part-3
The Monetary Policy Framework of Bangladesh Bank
3.1 Introduction..15
.
3.2 Monetary Policy Statement of Bangladesh Bank..16
3.3 Instruments on Monetary policy.....17
3.3.1 Required Reserve Ratio ...17
3.3.1.a Statutory Liquidity Ratio(SLR)...17
3.3.1 .b Cash reserve requirement (CRR)....18
3.3.2 Discount Rate (Bank Rate) ...19
3.3.3 Open Market Operations .20
3.3.4 Impacts of the Open Market Operations.....21
Part 4
The Concluding Part
4.1 Developing-developed debate on monetary policy..22
4.2 Conclusion...22
LIST OF TABLES
Table: 1.1 Types of monetary policy..5
Table- 2.1: Balance Sheet of the Central Bank...12
Flow charts
3
Part-1
Basics on Monetary Policy
1.1 Introduction
Monetary policy, both in developed and developing economies, seeks to maintain price stability
accompanied by sustained output growth in the face of internal and external shocks faced from time to
time. For developing economies like Bangladesh with significant underemployment/under exploitation of
production factors, supporting higher output growth is an overriding priority. Monetary policy of
Bangladesh Bank therefore aims at maintaining price stability while permitting monetary expansion
needed to support output growth at sustained high rate.
The Bangladesh Bank, thus, is not only responsible for monetary policy; it is also responsible for
development and regulation of the banking sector and key segments of financial markets, foreign
exchange management and public debt management. Though it is difficult but proper coordination of
these functions under one roof has been very helpful in preserving financial stability along with low
inflation and sustained high economic growth, and, therefore, to the practice of independent monetary
policy in Bangladesh.
1.1.1 An Overview
Globally, financial stability is emerging as an explicit objective for central banks only after the global
financial crisis. In Bangladesh, however, financial stability has been an explicit objective of the central
Bank since the early part of this past decade.
This unique and wide-ranging mandate grew out of, among other things, the growing degree of financial
deregulation and liberalization in Bangladesh combined with low income levels and limited capacity of
the majority of population to bear downside risks. Thus, unlike the trend toward a single objective (price
stability/inflation targeting), monetary policy framework in Bangladesh is based on multiple objectives
and instruments that recognize explicitly the risks of economic and financial instability while ensuring
price and growth stability.
Given some broad policy goals and objectives, Bangladesh Bank formulates and implements monetary
policy manages foreign exchange reserves and lays down prudential regulations and conduct monitoring
thereof as they apply to the entire banking system. The original 1972 Order stated the broad objectives of
the Bank: (a) to regulate the issue of the currency and the keeping of reserves; (b) to manage the
monetary and credit system of Bangladesh with a view to stabilizing domestic monetary value; (c) to
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preserve the par value of the Bangladesh Taka; (d) to promote and maintain a high level of production,
employment and real income in Bangladesh; and (e) to foster growth and development of the country's
productive resources for the national interest.
LM 0 . The initial demand side market equilibrium is established at the intersection of the IS
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and LM curves
Figure 2. Now assume that the government/ monetary authority wishes to increase (investment) demand.
Accordingly, it engages in an expansionary monetary policy, and raises the money stock.). The increase in
money stock shifts the LM curve rightward to
aggregate demand curve is shown by
depends very much on the shape of the aggregate supply schedule, AS. Economists are sharply divided on
this question. The classical economists assumed that the economy was always at the full employment
equilibrium such that the AS curve was vertical at the full employment output as shown by
AS C .
Keynes, on the other hand, suggested that it was quite possible for an economy to be caught in
underemployment equilibrium. In such an economy, it was possible to raise output without any increase
in the price level. The aggregate supply curve was accordingly horizontal at the existing price as shown
by
AS K . Depending on which aggregate supply curve actually prevails, we get two very different
outcomes of monetary policy. In the Keynesian construct, the shift of the aggregate demand curve to
E x . Output
r 0 to r 1 . The introduction of
the additional cash into the system through open market operations will create an excess demand for
bonds pushing down the interest rate. If the new cash is injected through required reserve changes or
outright money creation, the banking system has excess liquidity. They reduce the interest rate in order to
loan out more money. The eventual reduction in the interest rate, other things remaining the same, raises
the profitability of new investment encouraging businesses and households to undertake more investment
in plant, equipment and housing. This increase in investment has a multiplier effect on the economy such
that income ultimately rises by a multiple of the increase in investment. pushing down the interest rate. If
the new cash is injected through required reserve changes or outright money creation, the banking system
has excess liquidity. They reduce the interest rate in order to loan out more money. The eventual reduction
in the interest rate, other things remaining the same, raises the profitability of new investment
encouraging businesses and households to undertake more investment in plant, equipment and housing.
This increase in investment has a multiplier effect on the economy such that income ultimately rises by a
multiple of the increase in investment.
Interest rate
LM 0
LM 1
E0
r0
r1
E1
Y0
Y1
output
Figure - 1
Price level
AS C .
P1
E2
E0
P0
AS K .
AD 1
AS 0
C
Y0
Y1
Output
Figure -2
Whether monetary policy can affect the economy has been vigorously debated over the last several
decades. The new adherents of the classical proposition, i.e. the new classical economists, hotly deny any
role of monetary policy, even in the short run. The new method of modeling expectations, viz. rational
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expectations and perfect flexibility of wages and prices, ensure the ineffectiveness of monetary policy.
Others, however, recognize that the (new) classical position is more likely to pertain to the long run when
the economy has had time to adjust to its potential output; but in the short run, the aggregate supply curve
is not vertical, but upward sloping. With an upward sloping AS curve as shown by
output rises to Y' when the aggregate demand curve shifts out to
AS x
AS 0 in Figure 3,
in consequence of an
expansionary monetary policy. This increase is less than what would have been had the AS curve been
horizontal. The increase in output is, however, ephemeral.
When individuals become aware of the increase in the price level, they revise their price expectations
AS x
upward. The AS curve shifts upward until it rises to
and a new equilibrium at the potential
output is obtained. The monetary expansion is fully dissipated in the nominal price increase without
any effect on the real income.
AS 1
Price level
AS 0
P1
P0
AD 1
AD 0
Y0
Y'
Figure -3
The distinction between the various types of monetary policy lies primarily with the set of
instruments and target variables that are used by the monetary authority to achieve their goals.
Table: 1.1 Types of monetary policy
Monetary Policy:
Inflation Targeting
Monetary Aggregates The growth in money supply A given rate of change in the CPI
Gold Standard
Mixed Policy
The different types of policy are also called monetary regimes, in parallel to exchange rate
regimes. A fixed exchange rate is also an exchange rate regime; The Gold standard results in a
relatively fixed regime towards the currency of other countries on the gold standard and a
floating regime towards those that are not. Targeting inflation, the price level or other monetary
aggregates implies floating exchange rate unless the management of the relevant foreign
currencies is tracking exactly the same variables.
economy sufficiently incomplete, that the various lag in the process may turn out to be either
longer or shorter than initially expected.
Although many central bankers may do a good job of predicting future events, no central bank
has a crystal ballthe future is only clearly visible once you are there. Indeed, it is actually
worse than this in economics. Because of imperfect information that is often revised, even
several months after the fact, economists have a difficult time knowing with precision what is
happening in the current quarter until they are two or more quarters down the road. This mention
of imperfect information leads us to discuss the informational requirements for monetary policy.
In a nutshell, the successful conduct of monetary policy requires good information, and plenty
of it.
output observed?
6. Excess demand or supply. How quickly does the excess demand or supply associated with any
given output gap cause changes in the growth rate of wages and the prices of other inputs? How
quickly do these changes show up in inflation?
Eight examples of the second type of uncertainty- uncertainty about current and future
economic developments are described here, with the each referring to a different kind of shock
that can affect the economy. A brief description of each is as follows:
A. Portfolio adjustments. For several reasons, creditors may decide to adjust their holdings of
short-term and long-term Canadian securities, leading to changes in Canadian interest rates.
B. Foreign exchange market. Changes in exchange rates occur daily and for many reasons,
including changes in the growth of the global economy, changes in world commodity prices, and
changes in international asset portfolios.
C. Consumption and investment. Households change their spending, and firms change their
investment plans, often in unpredictable ways. Expectations regarding future economic
conditions are important.
D. Government expenditures. Governments change their spending on an annual basis, sometimes
in unexpected ways.
E. Net exports. Changes in foreign income lead to changes in the demand for Canadian exports.
The rise of specific countries in the production of certain goods frequently leads to changes in
world demand, either away from or towards Canadian goods.
F. Potential output. The economy's production capacity is not directly observable, and therefore
must be estimated. Its growth depends on labour-force growth, the accumulation of physical and
human capital, and the growth of productivity. Changes in potential output often cannot be
detected until well after the fact.
G. Inflation expectations. Large and sudden changes in the prices of specific products frequently
lead to changes in inflation expectations. However, the central bank's commitment and
credibility help to anchor expectations in the face of such shocks.
H. Inflation shocks. The rate of inflation is regularly affected by changes in indirect taxes, sharp
changes in the prices of specific products, and by changes in the exchange rate that alter the
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Canadian-dollar prices of imported products. Not every change in measured inflation is caused
by excess demand or supply in the Canadian economy.
This collection of uncertaintiesabout the economic linkages and the economic eventsis
crucial to the conduct of monetary policy, not least because of the long and variable lags that we
discussed earlier. For the Central bank to set its policy interest rate now in order to keep inflation
within its target range in the future, it is necessary for the Bank to anticipate the likely changes in
the economy that will occur over the next two years. It is also necessary for the Bank to
anticipate how its actions will be transmitted through the economy. Since no central bank has the
ability to foretell the future or has perfect knowledge of the various linkages in the economy, this
is a difficult task. But knowledge of the transmission mechanism, simplified as it is discussed,
permits the Bank to be systematic about which questions it asks, and to be analytical about
interpreting some of the answers.
This discussion underscores why monetary policy is best viewed as a problem of policy-making
under uncertainty. Faced with such uncertainty, the Bank needs to be forward-looking, aware of
many possible shocks that may occur in the near future. It must also be aware that economic
developments shown to be present by current data may not persist for long, or may in the near
future be revealed, through a revision of the data, never to have existed at all. Thus, the Bank is
forced to perform a precarious balancing actsometimes taking action in anticipation of what is
likely to happen while at other times waiting to see what new data are confirmed as genuine. Not
surprisingly, good judgment based on considerable experience is an essential part of good
monetary policy
To deal with the uncertainty regarding the various linkages between macroeconomic variables ,
the Bank needs to conduct a significant amount of economic research, both theoretical and
empirical, and to subject the results of this research to ongoing testing. The nature of modern
economies is such that this job will never be finished, and the complete set of answers will never
be known.
In short, the economic relationships that are central to the conduct of monetary policy are
difficult to pin down and are constantly changing. This simple fact requires the Bank to be
continuously conducting research on the nature of the transmission mechanism. To do otherwise
would be to abrogate its central responsibility.
The Importance of Current Analysis
Dealing with the uncertain developments in the domestic and world economies requires
information of a different kind. In order to know what events are occurring, and what events are
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likely to occur in the near future, the Bank needs to collect and analyze a great deal of current
dataa process that is often called current analysis. Although the relatively small number of
yellow starbursts in Chart 7 may suggest that the required effort in this direction is
commensurately small, this suggestion would be misleading. In fact, the large quantities of
variables that feed into each yellow starburst, and the inherent complexity involved in
understanding each individual variable, mean that the task of current analysis for any central
bank is Herculean. Thus, a great many people at the Bank are assigned the task of collecting and
analyzing data on hundreds of variables, from employment and exports to commodity prices and
housing starts, from government spending and exchange rate regimes to domestic steel
production and foreign crop failures. Only when the various shocks to the economy are observed
and understood can the Bank hope to incorporate that information fruitfully into its overall
decision-making.
A relatively new and important example of data collection and analysis that the Bank carries out
in an attempt to better understand the emerging trends in the economy are the Business Outlook
Survey (BOS). Four times a year the Bank's regional offices survey approximately 100 firms, the
overall sample chosen to be roughly representative of the economy. A number of issues are
explored, including the firms' views on likely future demand for their own products, capacity
pressures in their specific sectors, any emerging labour shortages, and the firms' own plans for
hiring or expansion. By analyzing these data carefully, the Bank is able to better understand how
firms respond to the various shocks affecting the economy.
Economic Projections
Economic research and current analysis are not independent activities. In order to conduct
thorough empirical economic research, knowledge of the data is essential, and such knowledge
typically comes from experience in current analysis. Conversely, the ability to interpret current
datawhat is going on and why?requires a thorough knowledge of economic relationships
that comes from experience in research. This ongoing interaction between research and current
analysis explains why many economists at the Central bank are in positions that require a regular
transition between current analysis duties and research projects.
The best example of how the insights gleaned from economic research are combined with the
knowledge embodied in current analysis is in the Bank's regular projection, or forecasting,
exercise, based on its large and complex statistical model of the economy, the Quarterly
Projection Model (QPM). Embodying the knowledge of economic relationships gained from
many years of research, QPM is a mathematical representation of the interaction of the various
agents in the economyhouseholds, firms, and governmentsand shows how these
relationships must evolve over time to be consistent with the underlying assumptions of agents'
behavior.
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Part-2:
14
2.1 Background
In the decades of seventies and eighties, monetary policies in Bangladesh were conducted with full direct
control on interest rates and exchange rates, as also on the volumes and directions of credit flows; the
dictated exchange rate served purpose as nominal anchor for prices. In such a directed regime with little
or no role of financial prices in influencing the magnitudes or directions of credit flows, market
participants and the general public were not much concerned about the ex-ante stance of monetary
policies, ex post information on monetary developments largely served purpose.
The situation began changing in the nineties with the abolition of directed lending and gradual
liberalization of interest rates; the change process culminating in transition to market based exchange rate
of Taka from 31st May 2003. From then on, interest rate and exchange rate are both market driven,
exchange rate is no longer in the role of nominal anchor for prices. In this fully market based regime exante pronouncement of monetary policy stance has assumed importance in anchoring inflation
expectations, and in influencing market exchange rate and interest rate trends towards growth paths of
monetary aggregates consistent with pre-announced target ranges for output growth and inflation.
15
Liabilities
Reserve Money
Currency
Currency held in banks
Currency in circulation
Deposits of DMBs
Other deposits
16
MB
The term high powered refer to the fact that an increase in the base money by Tk. 1 creates, through
the money multiplier, an increase of more than Tk. 1 in money supply.
Monetary base is typically the monetary liabilities of the central bank.
C
MB
The above pyramid indicates that in an economy currency in circulation is usually kept equal, but
fluctuate the amount of M1 based on reserve fluctuation as well as money multiplier.
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Demand Deposits (DD) in the banking system. Deposits are also money, because they can be
converted into currency and are used to settle debts e.g, current account, savings account,
traveler's check etc.
So, we can write the equation as, M1= C+DD ..(1)
2.2.4 Quasi Money (QM) includes time and savings deposit (TD) in the banking system
and any foreign currency deposit (FC) of residents;
QM = TD+FC (2)
2.2.5 Broad Money (M2) includes all liabilities of the banking system. It is defined as:
Broad Money = Narrow money + Quasi money
So, M2 = M1+QM.(3)
M2 includes everything in M1
Adds:
Savings deposits (SD) e.g, Post Office savings deposit.
Small denomination time deposits (TD) e.g, different fixed deposits,
Foreign currency deposits ( FC)
So, this equation can also be written as, M2=M1+SD+TD+FC
The basic balance equation of the monetary survey states that total liabilities are equal to total assets.
It implies that broad money (M2) is identical to net foreign assets (NFA) plus net domestic assets
(NDA):
M2 = NFA+ NDA(4)
Part-3
The Monetary Policy Framework of Bangladesh Bank
3.1 Introduction
The monetary policy framework of Bangladesh Bank identifies a logical and sequential set of actions
for designing and conducting the monetary policy. The framework is based on credible information
on the stability of the money demand function, the money supply process, and the monetary
transmission mechanism. Monetary policy in Bangladesh is framed using projected real GDP growth
rate. The targeted rate of inflation adopts Reserve Money (RM) and Broad money (M2) as operating
and intermediate targets respectively.
Within the framework, the monetary policy aims at supporting highest sustainable output
growth along with reasonable price stability and smooth adjustment to internal and external shocks
faced by the economy. The process uses repo, reverse repo, and Bangladesh Bank bill rates as policy
instruments for influencing financial and real sector prices toward the targeted path of inflation. The
underlying assumption is that growth of monetary aggregates (such as RM and M2) has a predictable
relationship with the domestic price level. Therefore, by controlling the growth of monetary
aggregates, Bangladesh Bank aims at achieving price stability. In practice, Bangladesh Bank sets a
growth rate of RM that is deemed to be consistent with targeted inflation and output growth, with the
idea that the RM growth will in turn lead, through money multiplier, to a given growth rate of M2 in
the economy.
Monetary policy consists of a set of rules that aim at regulating the supply of money in
accordance with predetermined goals. Monetary policy is important because it can influence
economic growth, inflation, and the balance of payments (BOP). The central bank conducts monetary
policy by using instruments that influence the supply of money and interest rates in the economy. The
fundamental objective of pursuing monetary policy by the central bank is to ensure that the
expansion in the money supply is consistent with the objectives of the government policies for
economic growth, inflation, and the BOP. In conducting monetary policy, the central bank tries to
ensure that the supply of money is in line with the amount of money demanded by the economic
agents: households and firms. The main policy goals of monetary policy of Bangladesh Bank are:
To achieve sustainable economic growth
To maintain price stability
To attain sustainable BoP.
19
20
Discount rate
Open Market Operation
Intermediate Targets
Money Supply
Policy Objectives
Sustainable growth
Domestic Credit
Low inflation
Sustainable balance of
payments
Reserve and Liquidity
management
21
22
23
maintain the intended level of liquidity. It can be mentioned that BB has introduced repo and
reverse repo operations from July 2002 and April 2003 respectively.
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Part 4
The Concluding Part
4.2 Conclusion
The key lesson from the Bangladeshi experience is that monetary policy needs to move away from a
narrow price stability/inflation targeting objective as may be warranted by circumstances. As guardians of
financial stability and lenders of last resort, central banks need to be concerned not only with monetary
policy but also with development and regulation of banks and key financial markets, like money, credit,
bond and currency markets. At the same time monetary authority should be concerned about the current
fiscal policy taking by government.
While price stability remains a key objective, an inflation targeting framework alone is inadequate
because Bangladesh is subject to a number of shocks and special regulatory and administrative structures
not necessarily present in the country. These shocks include supply shocks from vagaries of the
monsoon; large weight of food prices in various consumer price indices; large fiscal deficits and market
borrowings by Bangladesh government; and impediments to monetary transmission due to administered
interest rates in some government savings instruments.
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