MD Fardeen Kibria, 21205058

431 Research Paper

Effectiveness of Monetary Policy on Bangladesh’s Economy

Introduction
Bangladesh has always been characterized as one of the least developed countries in the world. However, recently, it has fulfilled the
requirements of graduating from LDC status- thanks to its outstanding economic performance over the last few decades. According to Rahman
(2023), Bangladesh is likely to complete its graduation by 2026. Leading up to this phase of development for the country, Bangladesh has been
quite successful in maintaining economic growth and averting any major economic crisis. According to Ali (2011), it is easier to maintain the
macroeconomic policies in order to grow and bring about development. However, as a country’s economy expands and becomes significant
enough, this task starts to prove more and more daunting. In order to maintain the vital macroeconomic policy of price stability, most Central
Banks around the world employ monetary policy and control the money supply circulating in the economy. An expansionary monetary policy
would stimulate the economy and allow for growth while a contractionary policy would restrict the price levels from going up. However, in
order for Bangladesh Bank to keep prices stable through
Therefore, this brings us to the question this paper will attempt to answer: is monetary policy effective in controlling inflation in Bangladesh?

Literature Review
Mone tary policy can be defined as the means used by the Central Bank in countries to influence the economy and price levels through
controlling money supply (Friedman, 2000). The primary way in how the central banks control the money supply is by raising or lowering the
interest rates. In the case of Bangladesh, the central bank (Bangladesh Bank) employs M2, repo rate, bank rate and other tools to influence the
money supply (Islam, 2008). Lowering the interest rate through these tools would cause a fall in inflation if the policy works. In a study done by
Alam (2015) using Structural Vector Autoregression shows that the impact of interest rates on output and pri nce is not significant. He argues
that this is due to the prevalence of microcredit and domestic credit is high in Bangladesh. Moreover, Hossain (2015) discusses the way this
policy is employed in Bangladesh and his findings implicate that not having a very flexible exchange rate system causes time incons
istency. This leads to low credibility of monetary policy and so it becomes unsuccessful in curbing inflation.

Research by Chowdhury et al (1995) illustrates that much of the exchange rate fluctuations of that time can be explained by the changes in
monetary policy and inflation. This research adds value because it shows the significance of monetary policy in affecting the economy. The
researchers also show that shocks due to the policies are short-lived. Although the paper is old, it provides many interesting conclusions related
to monetary policy. As per the research done by Huh and Lee (2021), some of the tools used by Bangladesh like reserve money and repo rate are
not effective enough as monetary policy. The effectiveness of monetary is quite different in developed nations like the USA. During COVID-19,
an expansionary monetary policy in the US by Federal Reserve led to a depreciation of US dollars which allowed for better competitiveness
internationally for USA (Feldkircher et al., 2021). By contrast, this expansionary monetary policy did not have any significant impact on
inflation according to their research. So, from this paper it can be seen that the difficulty in measuring the effectiveness in curbing inflation
through monetary policy is not just limited to countries like Bangladesh.
As to why monetary policy doesn’t work in many developing nations like Bangladesh can be owed to the lack of financial inclusion and good
institutions. Arshad et. al (2021) finds that monetary policy and financial inclusion have a reverse causality in developing countries which means
that better financial inclusion would enable a more effective monetary policy. Additionally, in order for policies to be effective, countries should
have good institutions. As Ali (2011) explained that in order for Bangladesh to grow sustainably, it needs to have good institutions. However,
institutions fail at their jobs due to significant corruption and malpractice regarding administration, leading to failed policies. Moreover, Nguyen
(2019) studied 32 emerging countries and found that a contractionary policy works best in reducing output effects when the country has a strong
financial system.

Other impacts of monetary policies could include environmental aspects. Bangladesh is a developing country with an incredibly high population
which causes a lot of environmental damage. That in turn leads to the loss of scarce resources such as its rivers. Scarcity can also lead to the rise
of prices so research needs to be done in this sector as has Lau et al. (2023) done research on the effectiveness of monetary policy along with
fiscal policy on stopping environmental damage. It finds that such policies are actually effective in slowing down environmental degradation.
However, this paper has not included Bangladesh in its research.

Overall, a substantial number of literatures has found that the impact of monetary policy on the economy of Bangladesh is not significant. In
contrast, other studies on the similar subject have found that such policies are more effective on developed economies like the USA.
Moreover, other aspects of monetary policy’s impact like on environmental damage control should be studied. Keeping all this mind, the next
section of this paper will delve into the effect of a higher interest rate on inflation through the use of Ordinary Least Square (OLS) regression.

Methodology
Does a higher rate of interest lead to lower inflation? An analysis using OLS
In order to test the effectiveness of monetary policy, this study will now look at the effect of a higher repo rate on the rate of inflation (CPI)
through OLS. Repo rate is the interest rate at which Bangladesh Bank lends money to the commercial banks and is one of the tools used to
implement monetary policy (Islam, 2008). The data used spans from July 2020 to December 2023, during which period the repo rate was
significantly raised by Bangladesh Bank. In this span the repo rate has gone up and therefore should lead to a fall in inflation. So, the null
hypothesis is that the autonomous rise in repo rate (interest rate) has no impact on CPI (inflation) while the alternative hypothesis is the opposite.
Natural log (ln) has been used on both variables to capture the percentage change instead of unit change. This analysis will look at the p-value of
the regression test at 95% confidence level. However, before looking at the p-value the study will also look at the sign of the slope coefficient as
it must be negative if monetary policy is effective- a higher interest rate must cause inflation to fall. If the sign is according to economic theory,
then we can look at the p-value.

ii. Data Analysis

Regression Statistics
Multiple R 0.94868106
R Square 0.89999575
Adjusted R
Square 0.89749564
Standard Error 0.07872709
Observations 42

ANOVA
Significanc
df SS MS F eF
Regression 1 2.23115842 2.23115842 359.983005 1.3192E-21
Residual 40 0.2479182 0.00619795
Total 41 2.47907662

Standard
Coefficients Error t Stat P-value Lower 95% Upper 95%
Intercept -1.1517318 0.16437737 -7.0066327 1.836E-08 -1.4839509 -0.8195128
X Variable 1 1 .8666494 0.09838338 18.9732181 1.3192E-21 1.66780916 2.06548963

iii. Interpretation

In order for the alternative hypothesis to be correct, the slope coefficient had to be negative. However, the regression returned a positive slope
coefficient which incorrectly suggests that a higher repo rate leads to a higher rate of CPI. Although the p-value is statistically significant under
95% confidence level, it is of no significance as the regression provides a completely reverse relationship of interest rate and inflation. Overall,
as the slope coefficient sign is positive instead of negative, we cannot reject the null hypothesis. Therefore, the regression analysis shows that
contractionary monetary policy of raising interest rates (repo rate in this case) is ineffective in the context of Bangladesh as inflation rate (CPI)
has kept rising regardless of this rise in interest rates.

Conclusion
In conclusion, this paper has investigated the effectiveness of Bangladesh’s monetary policy, especially on curbing the rate of inflation. As the
much of the literature cited has revealed that monetary policy is not that impactful in developing countries, this study has also found similar
findings. Adding to the existing literature, this paper has used a quantitative approach in determining the relationship. The hypothesized absence
of relationship between inflation (CPI) and interest rate (repo rate) could not be rejected as the regression results found that the sign was
incorrect. I believe that factors such as the existence of large formal economy and weak institutions in most sectors such as finance, hinders the
success of such policies. It is of high importance to conduct further research to examine these potential obstacles and determine which alternative
policy initiatives might be more effective in bringing about macroeconomic stability. The study's shortcomings emphasize the need for future
research to develop a more thorough knowledge of the effect of monetary policy in the Bangladeshi environment. The shortcomings of this paper
include the limitations of being confined within the use of only secondary data and lack of enough literature in this particular field. These
shortcomings indicate that proper data collection alongside research must be conducted on this topic to expose this issue.

References
Alam, Md. R. (2015). EFFECTIVENESS OF MONETARY POLICY IN BANGLADESH. The Journal of Developing Areas, 49(2), 363–372.
http://www.jstor.org/stable/24241314
Arshad, M. U., Ahmed, Z., Ramzan, A., Shabbir, M. N., Bashir, Z., & Khan, F. N. (2021). Financial inclusion and monetary policy
effectiveness: A sustainable development approach of developed and under-developed countries. PloS One, 16(12),
e0261337. https://doi.org/10.1371/journal.pone.0261337

Bangladesh Bank. (n.d.). https://www.bb.org.bd/en/index.php/econdata/inflation

Chowdhury, A., Dao, M. Q., & Wahid, A. N. (1995). Monetary policy, output and inflation in Bangladesh: a dynamic analysis. Applied
Economics Letters, 2(3), 51–55. https://doi.org/10.1080/135048595357555

Feldkircher, M., Huber, F., & Pfarrhofer, M. (2021). Measuring the effectiveness of US monetary policy during the COVID ‐19
recession. Scottish Journal of Political Economy, 68(3), 287–297. https://doi.org/10.1111/sjpe.12275

Friedman, Benjamin M., Monetary Policy (December 2000). NBER Working Paper No. w8057, Available at
SSRN: https://ssrn.com/abstract=254018

Hossain, A. A. (2015). Inflation volatility, economic growth and monetary policy in Bangladesh. Applied Economics, 47(52), 5667–
5688. https://doi.org/10.1080/00036846.2015.1054074

Huh, I. S., Lee, Y. (2021). Monetary Policy Transmission Mechanism of Bangladesh. https://doi.org/10.22617/wps210540-2

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Nguyen, T. M. L. (2019). Output Effects of Monetary Policy in Emerging and Developing Countries: Evidence from a Meta-Analysis. Emerging
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Rahman, M., (2023) Graduating from the LDC Group: Challenges Facing Bangladesh. South Centre | LDC Portal - International Support
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TRADING ECONOMICS. (n.d.). Bangladesh repo rate. https://tradingeconomics.com/bangladesh/interest-rate

Appendix

CPI Data (Y)

2020 2021 2022 2023
 January 5.02 5.86 8.57
February 5.32 6.17 8.78
March 5.47 6.22 9.33
April 5.56 6.29 9.24
May 5.26 7.42 9.94
June 5.64 7.56 9.74
July 5.53 5.36 7.48 9.69
August 5.68 5.54 9.52 9.92
September 5.97 5.59 9.10 9.63
October 6.44 5.70 8.91 9.93
November 5.52 5.98 8.85 9.49
December 5.29 6.05 8.71 9.41

Raw CPI data collected from Bangladesh Bank database on which Natural log was used to do the
regression

Repo Rate (interest rate) (X)

2020 2021 2022 2023
January 4.75 4.75 6
February 4.75 4.75 6
March 4.75 4.75 6
April 4.75 4.75 6
 May 4.75 5 6
June 4.75 5.5 6
July 4.75 4.75 5.5 6.5
August 4.75 4.75 5.5 6.5
September 4.75 4.75 5.75 6.5
October 4.75 4.75 5.75 6.5
November 4.75 4.75 5.75 6.5
December 4.75 4.75 5.75 6.5

Raw repo rate data collected from Trading Economics on which Natural log was used to do the
regression
 Inflation Scatter plot of inflation to interest rate
(CPI)
2.5

1.5
Y
Predicted Y
Y

0.5

0
1.5 1.55 1.6 1.65 1.7 1.75 1.8 1.85 1.9
Interest Rate (repo rate)

Scatter plot for the regression of inflation on interest rate

Graph showing the change in Repo rate over the last 4-5 years