Chapter One

Inflation

1.1 Introduction
During World War II, you could buy a loaf of bread for $0.15, a new car for less than $1,000 and
an average house for around $5,000. In the twenty-first century, bread, cars, houses and just
about everything else cost more. A lot more. Clearly, weve experienced a significant amount of
inflation over the last 60 years.
When inflation surged to double-digit levels in the mid- to late-1970s, Americans declared it
public enemy No.1. Since then, public anxiety has abated along with inflation, but people remain
fearful of inflation, even at the minimal levels weve seen over the past few years. Although its
common knowledge that prices go up over time, the general population doesnt understand the
forces behind inflation.

1.2 What is Inflation?

Inflation is defined as a sustained increase in the general level of prices for goods and services. It
is measured as an annual percentage increase. As inflation rises, every dollar you own buys a
smaller percentage of a good or service.

1.3 Causes of Inflation

Economists wake up in the morning hoping for a chance to debate the causes of inflation as it has
a great effect on economy. There is no one cause thats universally agreed upon, but at least two
theories are generally accepted:
(i) Demand-Pull Inflation This theory can be summarized as too much money
chasing too few goods. In other words, if demand is growing faster than supply,
prices will increase. This usually occurs in growing economies.
(ii) Cost-Push Inflation When companies costs go up, they need to increase prices to
maintain their profit margins. Increased costs can include things such as wages, taxes,
or increased costs of imports.

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1.4 Costs of Inflation
Almost everyone thinks inflation is evil, but it isnt necessarily so. Inflation affects different
people in different ways. It also depends on whether inflation is anticipated or unanticipated. If
the inflation rate corresponds to what the majority of people are expecting (anticipated inflation),
then we can compensate and the cost isnt high. For example, banks can vary their interest rates
and workers can negotiate contracts that include automatic wage hikes as the price level goes up.
Problems arise when there is unanticipated inflation:
Creditors lose and debtors gain if the lender does not anticipate inflation correctly. For
those who borrow, this is similar to getting an interest-free loan.
Uncertainty about what will happen next makes corporations and consumers less likely to
spend. This hurts economic output in the long run.
People living off a fixed-income, such as retirees, see a decline in their purchasing power
and, consequently, their standard of living.
The entire economy must absorb re-pricing costs (menu costs) as price lists, labels,
menus and more have to be updated.
If the inflation rate is greater than that of other countries, domestic products become less
competitive.
People like to complain about prices going up, but they often ignore the fact that wages should
be rising as well. The question shouldnt be whether inflation is rising, but whether its rising at a
quicker pace than your wages.
Finally, inflation is a sign that an economy is growing. In some situations, little inflation (or even
deflation) can be just as bad as high inflation. The lack of inflation may be an indication that the
economy is weakening. As you can see, its not so easy to label inflation as either good or bad
it depends on the overall economy as well as your personal situation.

1.5 Measures against inflation

The price situation in Bangladesh, like the case with many other developing countries, has, of
late, come under a fresh upward pressure. Its inflationary rate, as measured by consumers price
index (CPI) has, thus, crept up. The official inflation rate, which is now coming closer to double
digits, has prompted the countrys central bank, Bangladesh Bank (BB), to go for slowing down
of monetary growth to tame the price pressure. The BB is likely to continue its tight monetary

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policies to help keep inflation at bay. The BB hiked last week the cash reserve requirement
(CRR) for banks. Further squeeze in the statutory liquidity reserve (SLR) cannot be ruled out.
For the central bank, this is otherwise a rational course of action.
Yet then, the question remains whether application of monetary policies like the above in a
clinical fashion, would alone be effective in the Bangladesh context. For, the economy of this
country does not operate on a framework of textbook theories that say that inflation reflected in
rising prices of goods and services has too intimate a relationship with increased money supply
that creates demand which cannot be met under conditions of scarcity of existing stocks of goods
and services. Thus, prices are driven up. If it were so easy to control the effects of what is
understood as inflation rising prices and charges in the Bangladesh situation, then BBs
monetary policies of limiting inflation through monetary tools would have earlier paid off well.
On its part, the BB has otherwise been neither too tight-fisted in reducing money supply to
ensure that legitimate needs of credits could be met for the economys expansion nor too
reckless by being liberal in allowing the growth of money. It has been pursuing balanced
monetary policies over the years. But that has not paid the desired dividends; tighter policies
have not proved to be effective. Factors at work need to be traced for this. Such factors are not
all within the bounds of rational economic theories. Price escalations of commodities or hiking
up charges of services in many cases and rather on a regular basis are largely considered to
be caused by simple profiteering instincts, market imperfections of diverse sorts, lack of timely
policy-related actions or interventions on the part of the government etc. There are a large
number of essential commodities over the selling of which effective price monitoring,
appropriate policies to encourage supply-side responses and other accompanying measures from
the side of the government, have not been in place in a proper form and setting.
In this backdrop, the BB will have to be more agile and should act promptly even in the realm of
the supervision of the monetary affairs of the country. For instance, credible reports have
appeared in the media to the effect that a great deal of money, lent out from the banks over
nearly the last one year or more, have not gone into productive ventures or into industrialization
but to the countrys volatile stock market. In this situation, it is certainly no wonder that
inflationary pressure have been running strong.
Higher inflation does not, of course, signal proper economic management. The bringing down of
the rate of inflation is tantamount to removing maladies in the country such as institutional

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weaknesses, lack of expected improvements in promoting good governance, irregularities, funds
misappropriated or not utilized or utilized for wrong purposes, not increasing production and
even misdirected subsidies in some cases. Both economic and non-economic factors are involved
here. Hence, these all need to be properly addressed, if inflationary pressures are to be effectively
tamed.

1.6 Inflation Rate Definition

In mainstream economics, the word 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. Mainstream economist views can be broadly divided into two camps: the
monetarists who believe that monetary effects dominate all others in setting the rate of
inflation, and the Keynesians who believe that the interaction of money, interest and output
dominate over other effects. Other theories, such as those of the Austrian school of economics,
believe that an inflation of overall prices is a result from an increase in the supply of money by
central banking authorities.

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 Chapter Two
Inflation and Its Effect on Bangladesh

2.1 Bangladesh Inflation Rate: 1994-2016 | Data | Chart | Forecast

Consumer prices in Bangladesh increased 5.53 percent year-on-year in June of 2016, following
5.45 percent growth in the previous month. Food prices rose 4.23 percent (+3.81 percent in May)
and non-food went up 7.5 percent (+7.92 percent). It stays well below the government's target of
6.2 percent. Inflation Rate in Bangladesh averaged 6.65 percent from 1994 until 2016, reaching
an all time high of 16 percent in September of 2011 and a record low of -0.03 percent in
December of 1996. Inflation Rate in Bangladesh is reported by the Bangladesh Bureau of
Statistics.

7 BD Inflation Rate

6
Percentage Of Inflation Rate,%

0
Jul'14 Nov'14 Apr'15 Sep,15 Feb'16 Jun'16
Time Scale
Figure 2.1: Inflation Rate of Bangladesh (Time scale vs Percentage)

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 Actual Previous Highest Lowesr Dates Unit Frequency

5.53 5.45 16.00 -0.03 1994-2016 Percent Monthly 2005/06=100, NSA

In Bangladesh, the most important categories in the consumer price index are food, non-
alcoholic beverages and tobacco (59 percent of the total weight) and gross rent, fuel and lighting
(16.9 percent). The index also includes: clothing and footwear (6.9 percent); transport and
communication (4.2 percent), recreation, entertainment, education & cultural services (4.1
percent); miscellaneous goods and services (3.6 percent); medical care and health expenses (2.8
percent) and furnishing (2.7 percent). This provides the latest reported value for - Bangladesh
Inflation Rate - plus previous releases, historical high and low, short-term forecast and long-term
prediction, economic calendar, survey consensus and news. Bangladesh Inflation Rate - actual
data, historical chart and calendar of releases - was last updated on August of 2016.

Bangladesh Prices Last Previous Highest Lowest Unit

Inflation Rate 5.53 5.45 16.00 -0.03 percent

Consumer Price Index CPI 220.74 220.15 223.37 51.99 Index Points
GDP Deflator 174.42 174.42 224.46 126.35 percent
Producer Prices 2180.00 2082.00 2180.00 1233.00 Index Points
Export Prices 182.34 172.09 182.34 78.90 Index Points
Import Prices 211.90 200.37 211.90 89.90 Index Points
Inflation Rate Mom -1.44 0.05 2.08 -1.44 percent
Food Inflation 4.23 3.81 9.09 3.77 percent
Cpi Transportation 205.88 205.80 206.44 131.01 Index Points

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2.2 Effect on the Economy:

Figure 2.2: Classification of Inflation Effect

2.2.1 General Effect
An increase in the general level of prices implies a decrease in the purchasing power of the
currency. That is, when the general level of prices rises, each monetary unit buys fewer goods
and services. Increases in the price level (inflation) erode the real value of money (the functional
currency) and other items with an underlying monetary nature (e.g. loans and bonds).
For example if one takes a loan where the stated interest rate is 6% and the inflation rate is at
3%, the real interest rate that one are paying for the loan is 3%. It would also hold true that if one
had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20%one would have a
real interest rate of -14%

2.2.2 Negative effects of inflation

The main negative effects of inflation are: (1) It redistributes income from people on fixed
incomes (that do not rise with inflation) to people on variable incomes (that do rise with
inflation). Since most people with fixed incomes are poor (for example, receive social benefits
that do not rise in line with inflation), and people with variable incomes are relatively richer, the
effect of income is to redistribute income from the poor to the rich. (2) Inflation erodes
international competitiveness. Exports cost more abroad. This can cause a decrease in demand
for exports. That in turn can lead to a decrease in demand for the currency and to a devaluation

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of the currency. The devaluation may restore exports, but at the cost of making imports more
expensive, thus increasing inflation again! It is because inflation erodes international
competitiveness that most governments make controlling inflation the central pillar of their
economic policy.

2.2.3 Positive effects of inflation:

(i) Labor-market adjustments
Keynesians believe that nominal wages are slow to adjust downwards. This can lead to
prolonged disequilibrium and high unemployment in the labor market. Since inflation would
lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is
good for the economy, as it would allow labor markets to reach equilibrium faster.

(ii) Room to maneuver:

The primary tools for controlling the money supply are the ability to set the discount rate, the
rate at which banks can borrow from the central bank, and open market operations which are the
central banks interventions into the bonds market with the aim of affecting the nominal interest
rate. If an economy finds itself in a recession with already low, or even zero, nominal interest
rates, then the bank cannot cut these rates further (since negative nominal interest rates are
impossible) in order to stimulate the economy this situation is known as a liquidity trap. A
moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero
so that if the need arises the bank can cut the nominal interest rate.

(iii) Mundell-Tobin effect:

The Nobel laureate Robert Mundell noted that moderate inflation would induce savers to
substitute lending for some money holding as a means to finance future spending. That
substitution would cause market clearing real interest rates to fall. The lower real rate of interest
would induce more borrowing to finance investment. In a similar vein, Nobel laureate James
Tobin noted that such inflation would cause businesses to substitute investment in physical
capital (plant, equipment, and inventories) for money balances in their asset portfolios. That
substitution would mean choosing the making of investments with lower rates of real return.
(The rates of return are lower because the investments with higher rates of return were already

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being made before.) The two related effects are known as the Mundell-Tobin effect. Unless the
economy is already overinvesting according to models of economic growth theory, that extra
investment resulting from the effect would be seen as positive.

(iv) Instability with Deflation:

Economist S.C. Tsaing noted that once substantial deflation is expected, two important effects
will appear; both a result of money holding substituting for lending as a vehicle for saving. The
first was that continually falling prices and the resulting incentive to hoard money will cause
instability resulting from the likely increasing fear, while money hoards grow in value, that the
value of those hoards are at risk, as people realize that a movement to trade those money hoards
for real goods and assets will quickly drive those prices up. Any movement to spend those
hoards once started would become a tremendous avalanche, which could rampage for a long
time before it would spend itself. Thus, a regime of long-term deflation is likely to be
interrupted by periodic spikes of rapid inflation and consequent real economic disruptions.
Moderate and stable inflation would avoid such a seesawing of price movements.

(v) Financial Market Inefficiency with Deflation:

The second effect noted by Tsaing is that when savers have substituted money holding for
lending on financial markets, the role of those markets in channeling savings into investment is
undermined. With nominal interest rates driven to zero, or near zero, from the competition with a
high return money asset, there would be no price mechanism in whatever is left of those markets.
With financial markets effectively euthanized, the remaining goods and physical asset prices
would move in perverse directions. For example, an increased desire to save could not push
interest rates further down (and thereby stimulate investment) but would instead cause additional
money hoarding, driving consumer prices further down and making investment in consumer
goods production thereby less attractive. Moderate inflation, once its expectation is incorporated
into nominal interest rates, would give those interest rates room to go both up and down in
response to shifting investment opportunities, or savers preferences, and thus allow financial
markets to function in a more normal fashion.

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 Chapter Three
Concluding Remarks

3.1 Conclusion
This present the very recent insight of Bangladesh - inflation and its effects. It is clear that
inflation isnt intrinsically good or bad. Like so many things in life, the impact of inflation
depends on present situation.

Some points to remember:

Inflation is a sustained increase in the general level of prices for goods and services.
When inflation goes up, there is a decline in the purchasing power of money.
Variations on inflation include deflation, hyperinflation and stagflation.
Two theories as to the cause of inflation are demand-pull inflation and cost-push
inflation.
When there is unanticipated inflation, creditors lose, people on a fixed-income lose,
menu costs go up, uncertainty reduces spending and exporters arent as competitive.
Lack of inflation (or deflation) is not necessarily a good thing.
Inflation is measured with a price index.
The two main groups of price indexes that measure inflation are the Consumer Price
Index and the Producer Price Indexes.
Interest rates are decided in the U.S. by the Federal Reserve. Inflation plays a large
role in the Feds decisions regarding interest rates.
In the long term, stocks are good protection against inflation.
Inflation is a serious problem for fixed income investors. Its important to understand
the difference between nominal interest rates and real interest rates.
Inflation-indexed securities offer protection against inflation but offer low returns.

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