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Macro Term Paper
Macro Term Paper
Inflation.
Submitted to:
by : Sababa Islam
RQ 24, BBA 16
Introduction
This paper will focus on two main concepts and how they are related: Monetary Policy and
Inflation. The paper begins with an examination of the theories behind both concepts. The
current fluctuations in the inflation and the steps taken recently by the Central Bank to combat
inflation are examined against the steps taken historically by the Central bank, the instruments
used, and the changes later made.
What is Inflation?
To understand monetary policy, we need to first understand inflation. This is the term used to
describe the average rise in prices through the economy, meaning the rate at which money loses
value.
The underlying causes are twofold:
Demand Pull Inflation: Too much money is available to purchase too few goods and services,
or that demand in the economy is outpacing supply. In general, this occurs when an economy is
so buoyant that there are widespread shortages of labour and materials, and people can charge
higher prices for the same goods or services.
Cost Pull Inflation: Inflation can also be caused by a rise in the prices of imported commodities,
raw materials and wages. Prices rise as the cost of factors of production rises.
In under developed countries like Bangladesh, inflation is one of the key reasons for developing
a standard monetary policy. It is a crucial for Bangladesh bank (central bank of Bangladesh) to
adjust the inflation with the monetary policy.
Causes of Inflation
Causes of Demand Pull inflation:
Excess supply of money increases the demand for goods or services. In Bangladesh
flood, cyclone and for other natural disaster, the government of Bangladesh try to
increase the money supply to recover the situation. But it creates hyper inflation.
Therefore, Bangladesh bank has to pass a very difficult period to build up a well structure
monetary policy.
Increasing government expenditure on big development projects having long gestation
periods increases money supply as well as introduces inflation.
Excessive credit creation by banks to finance unproductive business may lead to
inflation.
When government pays off the public debt, purchasing power of the people increases and
so the demand.
Other Causes
Higher taxation also leads to a higher price level.
Devaluation also leads to inflationary consequences.
TYPES OF INFLATION
Creeping/mild inflation: when prices rise within a range of 10% over a decade or around
1% per annum, creeping inflation occurs.
Walking inflation: when prices rise by more than 10% and with a range of 30% to 40%
over a decade, or 3% to 4% a year, walking inflation is the outcome.
Running inflation: when price accelerates so rapidly that it goes beyond 100% over a
decade or 10% over a year, running inflation occurs.
Galloping/ hyperinflation: prices rise every moment and there is no limit to the height to
which prices might rise, meaning galloping or hyperinflation.
Paul Einzing:
Monetary policy includes all monetary decisions and measures irrespective of whether their
aims are monetary and non monetary and all non monetary decisions and measures that aim it
affecting the monetary system.
Harry G. Johnson:
Monetary policy employs the central bank’s control of supply of money as an instrument for
achieving the objectives of general economic policy.
C. K. Johri:
A monetary policy will consist of the decisions of the Government and the central bank, which
affect the volume, and consumption of money supply, the size distribution of credit the level and
structure of interest rates and the effect of these variables on the factors determining price and
output.
From their words we can gather that monetary policy refers to the central bank’s policy to
control of the availability, cost and use of money and credit in order to achieve some very
specific objectives, which we will discuss below.
Bank rate: It is the rate at which central bank lends money to the commercial banks. If
bank rate is increased it will increases the cost of borrowing of commercial banks, which
in turn reduces the capacity of credit creation of the commercial banks. In the opposite
way, a reduction in bank rate will increase the amount of credit created by commercial
banks.
Open market operation: Open market purchase of securities by the central bank will give
more power and money in the hands of commercial banks to expand credit creation. The
opposite will happen if there are sales of securities by the central bank.
Monetary policy in Bangladesh is formulated around inflation and output growth rates as the
basic policy targets. Levels and growth paths of relevant monetary aggregates such as reserve
money, broad money and domestic credit are also projected and monitored as intermediate
targets in conducting monetary policy. Consumer Price Index (CPI) inflation, expressed as the
rate of change of CPI, is used in Bangladesh for measuring price stability in conducting
monetary policy.
At the time Bangladesh suffered from high inflation with a war destructed poor economy.
Government efforts to reduce it by regulation were not effective, but both research and practical
experience overseas indicated that inflation could be reduced by controlling the money supply.
Inflation control by the central bank has historical precedent.
Monetary policy is a systematic and structured process. It changes on behalf of the demand of
the time. The Bangladesh Bank (BB) has been announcing its monetary policy stance on a
biannual basis through the Monetary Policy Statement (MPS) since January 2006. The policy
stances envisage ratio, reverse ratio, and BB bill rates as the routinely employed policy
instruments for influencing financial and real sector prices towards the targeted path of inflation.
The annual monetary programs adopt the reserve money and broad money as intermediate
targets; supported by a framework for regular
tracking of other asset and liability side sub-aggregates.
Major Monetary Policy Tools of Bangladesh
Since the beginning of the 1990's, Bangladesh Bank switched over to open market operations
mainly through government treasury bills (T-bills) auctions. Considering present excess liquidity
in the banking system, the central bank may opt for using one of these instruments (Table 1).
However, excess liquidity in the banking system also gives flexibility to the government for
increasing amount of borrowing from the banking system.
In order to streamline liquidity management and effective control of money supply, the
Bangladesh Bank introduced Repo and Reverses Repo instruments in 2003. Bangladesh Bank
uses short term interest rates e.g., Repo and Reverse Repo rates as indirect instruments of
monetary policy more frequently to inject liquidity or to mop up excess liquidity respectively
from the market to smooth money market operations and ensure liquidity management and bring
stability in relation to reserve money targets. Currently, BB frequently uses the Repo Rate as
lending fund to other commercial banks. In practice, bank rate has become obsolete.
At present, the money supply is regulated through indirect manipulation of reserve money
instead of credit ceiling. Major instruments of monetary control available with Bangladesh Bank
are the bank rate, open market operations, rediscount policy, and statutory reserve requirement.
Offering Repo has the same effect as selling Treasury Bills but the situation is vice versa for
buying Treasury Bills In recent years, central bank has been using indirect tools of monetary
policy rather than directly dictating them. Key policy rates, that is, Treasury bill/bond auction
yields, repo and reverse repo interest rate have been raised and maintained on upward trend.
Bangladesh Bank also enhanced its Repo and Reverse Repo interest rates by 25 basis points in
September and November 2008 respectively to 8.75 and 6.75 per cent to slow down the pace of
private credit growth. Inflation lowered on October 2008, and so the Bangladesh Bank revised
the inflation projection downward to 8.5 per cent in its second Monetary Policy Statement of
Fiscal Year 2009. As global economic recession weakened domestic economic activities, the
Repo and Reverse Repo rates were brought down to their earlier level in March 2009.
The central bank also made engagement in agriculture lending mandatory for all commercial
banks including private and foreign banks during this time. During the last quarter of Fiscal Year
2009, the BB introduced a 13 per cent interest cap for on lending, except for credit card and
consumer loans and allowed rescheduling of loans without any down payment until September
2009 to four export oriented sectors which were affected by fall in external demand viz. for
frozen food, jute, leather and textiles.
Taking note of the trends in global commodity markets, the Bangladesh Bank in its Monetary
Policy Statement for the first half of the fiscal year 2008-09 (FY09) set the inflation target at 9.0
percent and programmed adequate credit growth in order to support the GDP growth target of 6.5
per cent (Bangladesh Bank, 2009). A downward revision in CRR and SLR were made to enable
the banks to increase their lending capacity.
Projects which led to creation and expansion of output capacities were given priority for credit,
promoting agricultural and SME loans and discouraging expenditures on ostentatious
consumption. In order to reduce money supply, the Bangladesh Bank also announced that Cash
Reserve Ratio (CRR) should not be less than 4.5 per cent, up from 4.0 per cent, in any day of the
month; although, CRR on bi-weekly average remained unchanged at 5 per cent.
Bank rate
Until 1990, the use of this instrument as the lending rate of the central bank for borrowing of the
commercial banks to meet their temporary needs was virtually non-existent in Bangladesh. The
rate was changed in a few occasions only to align it with the re fixation of the rates of deposits
and advances.
However, since 1990, the instrument has been put in use to change the cost of borrowings for
banks and thereby to affect the market rate of interest. The lower the bank rate, the cheaper are
borrowed reserves and the more banks borrow. This leads to a reduction of money supply.
The central bank also mentioned that any bank that fails to adhere by its CRR guidelines will be
penalized at bank rate plus 5 per cent on the difference of the reserves.
This is a steep rise from when the present government assumed power, at which time the point-
to-point inflation fell to 2.25 percent in June 2009 from 10.04 percent in June 2008. The average
inflation rate was 6.6 percent during the same period, which was 9.94 percent one year back.
To contain inflation, the Central bank has increased the cash reserve requirement for banks in a
bid to contain inflation. With the new directive out, CRR (cash reserve ratio) will rise by 0.5
percentage point to 5.5 percent. This follows the trend in reserve ratio values shown in the graph
below.
The inflation started going up from July. In February 2010, it reached 9.06 percent on a point-to-
point basis.
Nowhere is the impact of inflation felt more than in the price of food. Food inflation rose in the
beginning and later non-food inflation also increased. In case of food inflation, the impact was
felt much on the price of rice. The price of coarse rice reached Tk 32 per kilogram in 2008 and
after this government assumed power the price fell to Tk 22 in the first half of 2009. After that
the rice price showed an upward trend and now the price of coarse rice is Tk 26 to Tk 27 per kg.
Lowering the cash reserve ratio in Bangladesh is one of the ways monetary poilic can be used to
reduce the inflation. Already Bangladesh Bank has taken steps geared towards reducing
withdrawing excess liquidity from the banks from August last year through reverse repo. Till
March this year it has mopped up around Tk 7,000 crore from the market. Increasing the reserve
ratio will reduce a further TK 2000 crore of liquidity.
These are ways to reduce liquidity preference. Once the population as a whole tends to save
rather tha spend, the liquidity will automatically fall, leading to a drop in inflation.
As the graph above shoes, as the rate of interest rises, the supply of money in the economy is
reduced and vice versa. This will increase investment, which will lead to growth in the GDP.
Conclusion: A Word of Caution
A reduction in the supply of money can lead to lower prices but also to the other bane of an
economy: unemployment. As money supply decreases, demand for goods and services decreases.
This leads to a reduction in demand, which therefore will lead to a reduction in supply. Firms
will find that it is no longer profitable to employ factors of production, including labour. This can
lead to layoffs, which will tax the government’s welfare programs. The government’s current
target of a 6% GDP growth will not be reached.
The governing bodies and the central bank should therefore use the monetary policies cautiously.
They can also use fiscal policies to reduce money supply, as well as other strategies beyond the
scope of this paper.
Citations
The Daily Star
http://www.thedailystar.net/newDesign/news-details.php?nid=132478
http://www.thedailystar.net/newDesign/news-details.php?nid=138900
http://www.thedailystar.net/newDesign/news-details.php?nid=137036
http://www.thedailystar.net/newDesign/news-details.php?nid=137155
Notes on the Monetary Policy Strategy of the Bangladesh Bank, Policy Notes Series PN0602,
Policy Analysis Unit, Bangladesh bank
Money and Banking, Md. Mofizer Rahaman,20 April, 2008, Patuakhali Science and Technology
University