Report on Critical Evaluation on the MPS 2020-2021

Course: F-635:

Central banking and Monetary Policy

Submitted to:

Mahabuba Lima

Assistant Professor

Department of Finance

University of Dhaka

Submitted by:
Tanmoy Biswas
ID: 42025

Date of Submission
12th July, 2021.
 Letter of Transmittal

12th July, 2021.

Mahabuba Lima

Assistant Professor

Department of Finance

Faculty of Business Studies

University of Dhaka

Subject: Request to Project Report.

Dear Sir,

I am very pleased to submit the report on “Report on Critical Evaluation on the MPS 2020-
2021”. I am assigned to prepare and submit this report as the partial fulfillment of the course
entitled “Central Banking and Monetary Policy” which carries the course code F-635. I have
tried my best to prepare this report perfectly. Nevertheless, this paper has been suffered by time
and cost limitation.

I will be obliged, if you kindly accept this report. I am ready to make you clear regarding any
confusion or further clarification from this term paper.

Sincerely yours,

Tanmoy Biswas

ID: 42025

Department of Finance

Faculty of Business Studies

University Of Dhaka

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Table of Contents
Report on Critical Evaluation on the MPS 2020-2021 ................................................................... 0
Letter of Transmittal ....................................................................................................................... 1
Introduction ..................................................................................................................................... 3
Monetary Policy .............................................................................................................................. 4
Money and Inflation ........................................................................................................................ 4
Role of Money ............................................................................................................................ 4
Role of Interest Rate ................................................................................................................... 4
Unemployment and Inflation ...................................................................................................... 5
Monetary and Fiscal Policy ........................................................................................................ 5
How Does Money Supply Affect Inflation? ................................................................................... 5
Quantity Theory .......................................................................................................................... 6
Significance of Monetary Policy .................................................................................................... 6
Tools of Monetary Policy ............................................................................................................... 7
a) Monetary base ......................................................................................................................... 7
b) Reserve requirements ............................................................................................................ 7
c) Discount window lending ...................................................................................................... 7
d) Interest rates ............................................................................................................................ 7
e) Currency board ...................................................................................................................... 7
Monetary Policy Decision- Making Process................................................................................... 7
Monetary Policy: Bangladesh Experience ...................................................................................... 8
Background of monetary policy in Bangladesh .......................................................................... 8
Strategy of Monetary Policy in Bangladesh ............................................................................... 8
Frameworks of Bangladesh’s Monetary Policy .............................................................................. 9
a) The Policy Target.................................................................................................................... 9
b) Inflation Target ....................................................................................................................... 9
c) Growth target .......................................................................................................................... 9
Monetary Policy Statement FY 2020-21 ........................................................................................ 9
Monetary Policy of Bangladesh and Its Impact on Economy....................................................... 10
Conclusion .................................................................................................................................... 11

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Introduction
Monetary policy is the policy adopted by the monetary authority of a nation to control either
the interest rate payable for very short-term borrowing or the money supply, often as an attempt
to reduce inflation or the interest rate, to ensure price stability and general trust of the value and
stability of the nation's currency. Monetary policy is a modification of the supply of money,
i.e. "printing" more money, or decreasing the money supply by changing interest rates or
removing excess reserves. Monetary policy is associated with interest rates and availability
of credit. Instruments of monetary policy have included short-term interest rates and bank
reserves through the monetary base. For many centuries there were only two forms of monetary
policy: altering coinage or the printing of paper money. Interest rates, while now thought of as
part of monetary authority, were not generally coordinated with the other forms of monetary
policy during this time. Monetary policy was considered as an executive decision, and was
generally implemented by the authority with seignior age (the power to coin). With the advent of
larger trading networks came the ability to define the currency value in terms of gold or silver,
and the price of the local currency in terms of foreign currencies. This official price could be
enforced by law, even if it varied from the market price.

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Monetary Policy
Monetary Policy is the term used by economists to describe ways of managing the supply of
money in an economy. Monetary policy is the management of money supply and
interest rates by central bank to influence prices and employment for achieving the
objectives of general economic policy. Monetary policy is the process by which the
monetary authority of a country controls the supply of money, often targeting a rate of
interest for the purpose of promoting economic growth and stability. The official goals
usually include relatively stable prices and low unemployment. Monetary theory provides
insight into how to craft optimal monetary policy. Monetary policy is the process by which
the government, central bank, or monetary authority of a country controls and also it is
the process by which the monetary authority of country controls the supply of money,
often targeting a rate of interest for the purpose of promoting economic growth and stability.

Money and Inflation

Monetary inflation is a sustained increase in the money supply of a country (or currency area).
Depending on many factors, especially public expectations, the fundamental state and
development of the economy, and the transmission mechanism, it is likely to result in price
inflation, which is usually just called "inflation", which is a rise in the general level of prices of
goods and services.

Role of Money
Money makes it easier to trade, borrow, save, invest, and compare the value of goods and
services.

 Money is anything widely accepted as final payment for goods and services.
 Money encourages specialization by decreasing the costs of exchange.
 The basic money supply in the United States consists of currency, coins, and checking
account deposits.
 In many economies, when banks make loans, the money supply increases; when loans are
paid off, the money supply decreases.

Role of Interest Rate

Interest rates, adjusted for inflation, rise and fall to balance the amount saved with the amount
borrowed, which affects the allocation of scarce resources between present and future uses.

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  An interest rate is the price of money that is borrowed or saved.
 Like other prices, interest rates are determined by the forces of supply and demand.
 The real interest rate is the nominal or current market interest rate minus the expected
rate of inflation.

Unemployment and Inflation

Unemployment imposes costs on individuals and nations. Unexpected inflation imposes costs on
many people and benefits some others because it arbitrarily redistributes purchasing power.
Inflation can reduce the rate of growth of national living standards because individuals and
organizations use resources to protect themselves against the uncertainty of future prices.

 Inflation is an increase in most prices; deflation is a decrease in most prices.

 Inflation reduces the value of money
 When people’s incomes increase more slowly than the inflation rate, their purchasing
power declines.
 The costs of inflation are different for different groups of people. Unexpected inflation
hurts savers and people on fixed incomes; it helps people who have borrowed money at a
fixed rate of interest.
 Inflation imposes costs on people beyond its effects on wealth distribution because
people devote resources to protect themselves from expected inflation.

Monetary and Fiscal Policy

Federal government budgetary policy and the Federal Reserve System’s monetary policy
influence the overall levels of employment, output, and prices.

 Monetary policies are decision by the Federal Reserve System that lead to changes in the
supply of money and the availability of credit. Changes in the money supply can
influence overall levels of spending, employment, and prices in the economy by inducing
changes in interest rates charged for credit and by affecting the levels of personal and
business investment spending.

How Does Money Supply Affect Inflation?

Inflation can happen if the money supply grows faster than the economic output under otherwise
normal economic circumstances. Inflation, or the rate at which the average price of goods or
serves increases over time, can also be affected by factors beyond the money supply.

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The theory most discussed when looking at the link between inflation and money supply is
the quantity theory of money (QTM), but there are other theories that challenge it.

Quantity Theory
The quantity theory of money proposes that the exchange value of money is determined like any
other good, with supply and demand. The basic equation for the quantity theory is called The
Fisher Equation because it was developed by American economist Irving Fisher.1 In it's simplest
form, it looks like this:

(M)(V)=(P)(T)

M=Money Supply

V=Velocity of circulation (the number of times money changes hands)

P=Average Price Level

T=Volume of transactions of goods and services.

Some variants of the quantity theory propose that inflation and deflation occur proportionately to
increases or decreases in the supply of money. Empirical evidence has not demonstrated this, and
most economists do not hold this view.

A more nuanced version of the quantity theory adds two caveats:

1. New money has to actually circulate in the economy to cause inflation.

2. Inflation is relative—not absolute.

In other words, prices tend to be higher than they otherwise would have been if more dollar bills
are involved in economic transactions.

Significance of Monetary Policy

The Monetary Policy has a great significance on economy. Some of there are as follows.
(www.bangladesh-bank.org)

i)To control supply of money

ii) To Setup rate of interest.

iii) To promote economic growth & stability.

iv) To stabilize price & low unemployment.

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v) To control inflation & deflation.

Tools of Monetary Policy

a) Monetary base
Monetary policy can be implemented by changing the size of the monetary base. Central banks
use open market operations to change the monetary base. The central bank buys or sells reserve
assets (usually financial instruments such as bonds) in exchange for money on deposit at the
central bank. Those deposits are convertible to currency.

b) Reserve requirements
The monetary authority exerts regulatory control over banks. Monetary policy can be
implemented by changing the proportion of total assets that banks must hold in reserve with the
central bank. Banks only maintain a small portion of their assets as cash available for immediate
withdrawal; the rest is invested in illiquid assets like mortgages and loans. By changing the
proportion of total assets to be held as liquid cash, the Federal Reserve changes the availability
of loan able funds. This acts as a change in the money supply

c) Discount window lending

Discount window lending is where the commercial banks, and other depository institutions, are
able to borrow reserves from the Central Bank at a discount rate. This rate is usually set below
short term market rates (T-bills).It is of note that the Discount Window is the only instrument
which the Central Banks do not have total control over.

d) Interest rates
The contraction of the monetary supply can be achieved indirectly by increasing the nominal
interest rates. Monetary authorities in different nations have differing levels of control of
economy-wide interest rates. . By raising the interest rate under its control, a monetary authority
can contract the money supply, because higher interest rates encourage savings and discourage
borrowing. Both of these effects reduce the size of the money supply.

e) Currency board
A currency board is a monetary arrangement that pegs the monetary base of one country to
another, the anchor nation. As such, it essentially operates as a hard fixed exchange rate,
whereby local currency in circulation is backed by foreign currency from the anchor nation at a
fixed rate. Thus, to grow the local monetary base an equivalent amount of foreign currency must
be held in reserves with the currency board. This limits the possibility for the local monetary
authority to inflate or pursue other objectives.

Monetary Policy Decision- Making Process

The MPC sets monetary policy that is consistent with domestic economic conditions to ensure
price stability and sustainable economic growth. In addition, the MPC plays an important role in

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determining guidelines for exchange rate policy that is consistent with the monetary policy
stance. Approximately every six weeks ( 8 times a year), the MPC needs to assess the economic
and financial condition as well as the risk factors that may affect future inflation and economic
growth in its consideration of monetary policy direction. In each meeting the MPC secretariat
presents the latest economic data on financial market conditions, fiscal position, international
financial environment, and production, as well as other factors that may affect the price level,
including world commodity prices and US interest rates. The plausible trends of these variables
are widely discussed and subsequently incorporated into the inflation and GDP forecasts.

The Bangladesh Bank undertakes open market operations to ensure that the policy rate is held- as
close as possible- to the level determined by the MPC. Each quarter, the Bangladesh Bank
publishes a quarterly inflationary report to present the latest economic and inflation forecasts to
the MPC in a clear and forward looking manner, as well as communicates to the general public
views of the MPC to in reaching their various policy decisions. (Bangladesh Economic Review
1999, Ministry of Finance, Government of Bangladesh.)

Monetary Policy: Bangladesh Experience

Background of monetary policy in Bangladesh

The policy adopted by the central bank for control of the supply of money as an instrument for
achieving the objectives of general economic policy. As stated in the Bangladesh Bank order
1972, the principal objectives of the countries monetary policy are to regulate currency and
reserves. To manage the monetary and credit system; to preserve the par value of domestic
currency ; to promote and maintain a high level of production, employment and real income ;
and to foster growth and development of the country’s productive resources in the best national
interest. Although the long term focus of monetary policy in Bangladesh is on growth with
stability, the short term objectives are determined after a careful and realistic appraisal of the
current economic situation of the country.

Strategy of Monetary Policy in Bangladesh

The MPS (Monetary Policy Statement) starts with expression of the monetary policy frameworks
in terms of the goals, instruments, and the channels of transmission. Maintaining price stability
while supporting the highest sustainable output growth is the stated objective of monetary
policies pursued by the Bangladesh Bank.

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Frameworks of Bangladesh’s Monetary Policy

a) The Policy Target

In this backdrop it is necessary that the monetary policy framework (in terms of the goals, the
instruments, and the analytic channels of transmission) be articulated for greater clarity and
transparency benefiting both the policy makers as well as the stakeholders. A policy system,
where the goals are transparent and their achievement verifiable, directly adds to the credibility
of the central bank, a major objective of this document is to define such a framework. Most
industrial economy monetary policy is run with the task of keeping watch on both the output gap
(i.e., the deviation of actual output from its long-run equilibrium level) and the inflation gap,
which is similarly defined. In contrast, however, the challenge in the developing world is how to
augment the capacity output through both productivity growths as well as via the installation of
additional capacity.

b) Inflation Target
It is the general wisdom that monetary policy tools are of immediate influence in controlling
inflation. However contemporary evidence amply illustrates that monetary policy cannot deal
well with the inflationary impact of external shocks such as the recent international price of oil
and related energy products. Many central banks as a consequence focus on the core inflation,
which is typically constructed by subtracting the most volatile components (e.g., food and energy
prices, indirect taxes etc) from the consumer price index (CPI).

c) Growth target
GDP growth projections of the Medium Term Macroeconomic Framework (MTMF) in the
government’s National Strategy for Accelerated Poverty Reduction (NSAPR), modified
appropriately in the light of unfolding actual developments, are used as output growth targets for
the purpose of monetary policies.

Monetary Policy Statement FY 2020-21

Bangladesh Bank has announced an expansionary policy stance for the FY 2020/21, to meet the
need for additional funding required to restore the country’s economy affected by Covid-19

The monetary policy tools available for crisis situations are dwindling for central banks around
the world. Cutting interest rate to near zero level (some even in negative territory) and QE (bond
buying program) are losing their impact gradually.

Bangladesh Bank has come out with all guns blazing. The 2020-21 MPS is expansionary and
growth accommodative. Key interest rates have been slashed by a good amount. The central
bank is fully aware of the fallout due to the pandemic, severe flood, lingering slowdown of the

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local economy, rising bad assets in the banking sector and sluggish global economy. More than
BDT 1 trillion (about USD 12 billion) stimulus package has already been announced by the
Government to aid the faltering economy. BB is trying to ensure availability of adequate
liquidity at low cost for propping up the business climate.

Are these policy changes enough to regenerate employment and revive the economy? This would
only work in this crisis when people and businesses are confident of a win against the
coronavirus. Banks are supporting all types of businesses with interest deferral, moratorium and
low-cost financing. No major change has been advised for banks in managing their credit risk
and piling bad debt. However, this is unprecedented situation and making credit available at low
cost is the best bet for any central bank in the world. BB has done the same thing; we only wait
for a better control of the pandemic by our government.

An expansionary, growth accommodative policy stance for the FY’21 in consideration of

impediments caused by ongoing COVID-19 pandemic, seasonal floods, and international
sluggish economic and volatile price situations.

Bangladesh bank endures an expansionary, growth accommodative policy stance for the FY’21
in response to the additional fund requirements for restoring country economy. Recent MPS
focuses on:

 Accommodating credit to available sectors while recovering economy from the adversity
caused by COVID19 pandemic and rehabilitation of the production capacity to restore
growth.
 Keeping CPI inflation contained within the targeted ceiling of 5.04 to 5.93%.

Monetary Policy of Bangladesh and Its Impact on Economy

Monetary policy is concerned with the measures taken to control the supply of money, the cost
and availability of credit. Further, it also deals with the distribution of credit between the uses
and the users, the lending and borrowing rates of the banks. In a developing country like ours the
monetary policy has been effectively used as a tool for overcoming depression and inflation.

Monetary policies can promote economic growth by ensuring adequate availability of credit and
lower cost of credit. Easy availability of credits at low interest rate stimulation investment and
thereby quickens economic growth.

“Monetary policies at the second half of the FY07 continue to aim it supporting annual real GDP
of 7.0 percent, while keeping the inflationary pressure under control.”

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According to Bangladesh Bank a tight monetary policy will provide the appropriate environment
under which the growth can occur in the long run. But in the short run there exists tradeoff
between growth and inflation. Higher economic growth gives rise to money supply which leads
an increase in aggregate demand and cause inflation.

A developing country like Bangladesh needs both control over inflation and a sustainable
economic growth. Only by expanding the real scope of growth this objective can be achieved.
When money supply exceeds the output the aggregate demand rises beyond the ability of
economy. Only by increasing real scope govt. can increases aggregate demand effectively with
our any side effect. The growth rates of currency in circulation and demand deposits indicate the
extent of inflationary bias. In FY05, growth rates of credit to public and private sectors both
exceeded program levels, showing excess demand and inflationary bias, which also showed up
on the liability side.

Conclusion
The monetary policy allows the policymakers to control the supply of money and credit in the
economy. Taking two opposite directions, we have the two forms of monetary policies,
expansionary and contractionary. Out of these two, the expansionary monetary policy is sought
as a way out for the policymakers to pull the economy from a period of the economic slump
through injecting credit into the economy and promoting economic growth within the economy.
As the economies run along the course of business cycles, depression, and recovery is a part of
their cyclical economic fluctuations, reducing and increasing policy interest rate relative to the
changes in the real GDP and inflation is rather common. However, the cyclical fluctuations in
the business cycles can be led astray by the occurrence of unprecedented events and/or natural
disasters which affect the productive capacity of the economy in short-run, along with having
long-run repercussions. One such event which surfaced on the world economic landscape was
the outbreak of the coronavirus, in January 2020, as declared by the World Health Organization.
The virus outbreak soon gained momentum and evolved into a global pandemic, which sent the
policymakers into a flurry of safety procedures and several stringent measures were imposed
including national lockdowns as well as travel restrictions and public curfews. The series of
events that followed had a detrimental impact on the production and consumption levels in the
economies worldwide. This event can be seen as a trigger for changes being made in the
monetary policies worldwide to ensure that the productive capacity of the economies is not
majorly affected and the economy does not fall to the abyss of economic recession.

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