Assignment on

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 2.2.6 Calculating the Contributions to the Growth of Money Supply...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

Table3.1: Instruments of monetary policy....17

Flow charts
3.1: Monetary Policy Framework of Bangladesh Bank..16
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3.2: Trends in SLR & CRR .......19 3.2: Trends in Repo& Reverse Repo.21

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 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. 4

1.1.2 Definition of Monetary Policy & Fiscal policy

Monetary policy is a set of rules that aims at regulating the supply of money in accordance with predetermined goals or objectives. Monetary policy is concerned with how much money circulates in the economy and what that money is worth. It s 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. By keeping inflation low, stable and predictable, the Bank contributes to solid economic performance and rising living standards for the people of that country. Another related policy action is fiscal policy. Fiscal policy is the use of government spending and revenue collection to influence the economy. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand , and decreasing spending & increasing taxes after the economic boom begins. Fiscal policy can be contrasted with monetary policy, which attempts to stabilize the economy by controlling interest rates and spending.

1.2 Objectives of monetary policy

The objectives of monetary policy in Bangladesh aim at growth, stability and social justice. After the Keynesian revolution in economics, many people accepted significance of monetary policy in attaining following objectives. _ Rapid Economic Growth _ Price Stability _ Exchange Rate Stability _ Balance of Payments (BOP) Equilibrium _ Full Employment _ Neutrality of Money _ Equal Income Distribution

1.3 Theory Behind Monetary Policy

The effects of monetary policy are easily demonstrated with the help of the standard IS-LM and aggregate demand supply analysis. Although there are several instruments of monetary policy, it is customary to conduct the analysis in terms of an increase in money stock. This is not altogether unrealistic or inappropriate; whatever instruments are chosen, they are likely to impact on the money stock. Figure 1 shows a goods market equilibrium schedule, and a money market equilibrium schedule, . The initial demand side market equilibrium is established at the intersection of the IS and LM curves . The aggregate demand schedule corresponding to these curves is shown by AD in 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 in Figure 1. The corresponding shift of the aggregate demand curve is shown by in Figure 2. What ultimately happens in the economy depends very much 5

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 . 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 . 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 . moves the economy from its initial equilibrium to the finad equilibrium . Output rises unambiguously from Yo to . This increase in output is brought about by the fact that the expansionary monetary policy reduces the market interest rate from to . 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

output Figure - 1

Price level .

C 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 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 in Figure 3, output rises to Y' when the aggregate demand curve shifts out to 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 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.
Price level

Figure -3

1.4 Types of monetary policy

In practice, to implement any type of monetary policy the main tool used is modifying the amount of base money in circulation. The monetary authority does this by buying or selling financial assetsThese open market operations change either the amount of money or its liquidity (if less liquid forms of money are bought or sold). The multiplier effect of fractional reserve banking amplifies the effects of these actions. Constant market transactions by the monetary authority modify the supply of currency and this impacts other market variables such as short term interest rates and the exchange rate.

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 Price Level Targeting Monetary Aggregates Fixed Exchange Rate Gold Standard Mixed Policy Target Market Variable: Long Term Objective: Interest rate on overnight A given rate of change in the CPI debt Interest rate on overnight debt A specific CPI number

The growth in money supply A given rate of change in the CPI The spot price of the currency The spot price of gold Usually interest rates The spot price of the currency Low inflation as measured by the gold price Usually unemployment + CPI change

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.

1.5 Time and uncertainty

Uncertainty plays a very important role in determination and application of monetary policy. Economists usually think of the transmission mechanism as containing "long and variable lags," indicating not only that central bankers must be patient while waiting for the results of their policy actions, but also that they must be prepared to accept a few surprises while they're waiting. The workings of the economy are sufficiently complex, and our understanding of the 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.

1.5.1 Monetary policy faces two types of uncertainty

In order to understand the informational requirements for monetary policy, it is helpful to reconsider the nature of the transmission mechanism. Transmission mechanism again, but adds two types of uncertainty. The first type involves uncertainty about the details in the transmission mechanism itself; that is, uncertainty about the precise nature of the linkages between key macroeconomic variables. This uncertainty is shown by the pink numbered balloons. The second type is uncertainty about current and future economic developments in the domestic and world economies, as shown by the yellow starbursts. Six instances of the first kind of uncertainty are shown in here, each referring to a different aspect of the transmission mechanism. The nature of the uncertainty in each case is as follows: 1. Term structure. How do the Bank's changes in the target overnight interest rate lead to changes in longer-term interest rates? Are the changes always in the same direction? What magnitude of changes are observed for longer-term interest rates?

2. Foreign exchange market. How do the Bank's changes in the target overnight interest rate lead to changes in the exchange rate? How big a change in the exchange rate typically follows a change in the policy rate by the Central bank?

3. Interest sensitivity of spending. How much, and over what timeframe, do aggregate consumption and investment respond to changes in longer-term interest rates? Do different components of consumption and investment have different responses to changes in interest rates?

4. Sensitivity of net exports. How much do exports respond to a change in the exchange rate, and with what time lags? How quickly and in what magnitude do imports respond to the same change in the exchange rate?

5. The multiplier. How big is the "multiplier" that connects initial changes in aggregate demand to the overall change in aggregate output? Over what time period are the full effects on aggregate 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.

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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 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

1.5.2 Dealing with uncertainty:

In addition to judgment and experience, consider what the Central bankand any other central bankrequires in order conducting the best possible monetary policy in the face of uncertainty.
The Role of Research

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
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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 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.

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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. These three exercises in information creationresearch, current analysis, and economic projectionsare imperfect and, necessarily, ongoing. Research will never be entirely "correct" and thus will never be complete. Current analysis, by its very nature, must be an ongoing process, with constant effort expended to improve data definitions and accuracy. And the art of model building and producing sensible and consistent macroeconomic projections is, perhaps unbelievably, still in its infancy. Such failings, however, in no way suggest that these activities can be forsaken. It would be impossible to conduct prudent monetary policy without the creation and provision of such information, and it is thus not surprising that central banks the world over invest considerable resources in these three key activities

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Part-2: The Money Supply Procedure of Bangladesh Bank

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.

The key players in the money supply process as follows: 1. The Central Bank- The government agency that oversees the banking system and is responsible for the conduct of monetary policy; in Bangladesh, it is Bangladesh Bank. 2. Banks (depository money banks (DMBs)) - The financial intermediaries that accept deposits from individual and institutions and make loans : commercial banks, savings and loan associations, mutual savings banks and credit unions. 3. Depositors- individuals and institutions that hold deposits in banks. Of the three players, the central bank in Bangladesh, Bangladesh Bank is the most important. The conduct of monetary policy by Bangladesh Bank involves actions that affect its balance sheet (holding of assets and liabilities) to which we turn now.

2.2 The Central Banks Balance Sheet:

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To realize the dynamics of money supply process in Bangladesh, the balance sheets of the central bank, depository money banks (DMBs) and the monetary survey of the banking system need to be studied.

Table- 2.1: Balance Sheet of the Central Bank Assets Net Foreign Assets Net Domestic Assets Net Domestic Credit Net claims on government Claims on DMBs Claims on the private sector Other items net Liabilities Reserve Money Currency Currency held in banks Currency in circulation Deposits of DMBs Other deposits

Net foreign assets include the following items: On the assets side, official international reserves (including gold, foreign exchange, the reserve position of the country in the IMF, and holdings of special drawing rights); On the liability side, short-term liabilities to foreign central banks, including their deposits, swap facilities, overdrafts, and some medium and long-term debt; such as the countrys use of IMF credit; and Other foreign assets and liabilities not included in the definition of official reserves. Net domestic assets include both net domestic credit and other items, net. Net domestic credit comprises several claims: net claims on the government, claims on DMBs, and claims on other domestic sectors. Let us now turn to the liabilities side of the balance sheet: Reserve money is sometimes called high powered money, base money, or the monetary base. It includes the following core items: Currency in circulation (the amount of currency in the hands of the public); Reserves of DMBs with the central bank. Reserves consists of their deposits at the central bank plus currency that is physically held by banks ( called vault cash). Reserve money excludes: The governments deposit with the central bank; and Central bank liabilities to non-residents. Currency in circulation depends on the asset side of the balance sheet and is a liability to the central bank. The total assets always be equal to the liability as per accounting principles.
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2.2.1The Monetary Base:

Reserve money or the monetary base, also called high powered money consists of C & R: C +R Currency in the hand of the public + Reserves of the banking system (Reserves of Depository Money Banks (DMBs) with the central bank. Reserves consist of their deposits at the central bank plus currency that is physically held by banks called vault cash). = Monetary Base

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.

2.2.2 Money Stock Pyramid

M1 C D

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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2.2.3 Narrow Money (M1):

M1 consists of: Currency in circulation (C) which includes the notes and coins that we use plus, 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)

2.2.6 Calculating the Contributions to the Growth of Money Supply:

There are three approaches to calculate the contributions to the growth of money supply, those are: The basic balance equation of the monetary survey. The money multiplier, a ratio that relates the change in the money supply to a given change in the monetary base. Income velocity of circulation showing the relationship between M2 and nominal GDP. Let us now focus on the basic balance equation of the monetary survey (equation 4). A change in M2 stems from a change in NFA, or in NDA, or both: M2= NFA + NDA..(5) This identity states that the money supply increases when a BOP surplus exists. A surplus in the BOP shows up as an increase in NFA. NDA increases if the banks extend credit to the private sector or to the government.

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We now want to know about the primary determinants of the growth in the money supply. We can answer this question by dividing both sides of equation (5) by the stock of money at the end of the previous period. This stock of money is identified as M2 :
t-1

M2/ M2 = NFA/ M2 + NDA/ M2 .(6)

t-1 t-1 t-1

Using equation (6), we may calculate the contributions of the BOP and of NDA to the percentage changes in the money supply in Bangladesh.

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.
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3.2 Monetary Policy Statement of Bangladesh Bank

Monetary Policy Statement (MPS) was first issued by the Bangladesh Bank in January 2006. The MPS is intended to present for general information on Bangladesh Bank's outlook on real sector and monetary developments over the immediate future and the monetary policy stance it pursue, based on its assessment of the developments over the preceding quarters. The MPS starts with articulation of the monetary policy framework 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.
The Monetary Policy Statement (MPS) is intended to outline the objective and the modalities of formulation and conducting of monetary policies by the Bangladesh Bank, its assessment of the recent and the expected monetary and price developments, and the stance of monetary policies that will be pursued over the near term . Objectives of the monetary policies of the Bangladesh Bank as outlined in the Bangladesh Bank Order, 1972 comprise attaining and maintaining of price stability, high levels of production, employment and economic growth.

Flow chart-3.1: Monetary Policy Framework of Bangladesh Bank

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Policy Instruments: Repo & reverse repo auctions Various T-bill auctions Setting SLR & CRR Bank rate

Targets: Operating target * Reserve money Intermediate target * Broad money Goals: Sustainable economic growth Price stability Sustainable BoP

Information Variables: Foreign reserves Policy Decision: Based on market information and judgment of policy markers Short-term interest rate Liquidity situation Domestic credit Inflation and exchange rate

Table3.1: Instruments of monetary policy

Instruments Direct Instruments Indirect Instruments Required Reserve Ratio Discount rate Open Market Operation

Operating Targets Reserve Money Short term interest rate

Intermediate Targets Money Supply Domestic Credit Long-term interest rate

Policy Objectives Sustainable growth Low inflation Sustainable balance of payments Reserve and Liquidity management

3.3 Indirect Instruments on the Money Supply: Historically, the direct instruments to control the money supply have been popular, particularly in developing countries. However, the more recent trend has been to substitute indirect instruments for direct instruments. Three examples below show as to how Bangladesh Bank can use indirect instruments to increase or decrease the money supply.

3.3.1 Required Reserve Ratio:

The required reserve ratio is the amount of reserves as a percentage of their deposits that banks are required to hold. These reserves may be held in the form of cash in the vault or as deposits with the Bangladesh Bank. Bangladesh Bank can decide whether or not it will pay interest on these deposits. Changes in reserve requirement affect the money supply by causing the money multiplier to change.
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For example: if Bangladesh Bank wants to increase the money supply, it decreases the required reserve ratio. As soon as it does, deposit money banks (DMBs) have additional free reserve that they can lend. Because reserves generally earn no interest, banks will increase their lending until all unutilized reserves are invested in interest- earning assets. The increase in bank credit increases the money supply. If BB wants to decrease the money supply, it increases the required reserve ratio. To increase their reserves, DMBs must decrease their lending. This leads to decline in money supply. The present reserve requirement ratio of Bangladesh Bank is 23% of which 5% is cash reserve requirement (CRR) and 18% statutory liquidity reserve (SLR).

3.3.1 .a Statutory Liquidity Ratio(SLR)

The SLR is commonly used to contain inflation and fuel growth, by increasing or decreasing it respectively. This counter acts by decreasing or increasing the money supply in the system respectively. In terms of section 33(1) of the Bank Company Act of 1991, the Statutory Liquidity Requirement (SLR) is the minimum (in percentage of total time and demand liabilities) that a scheduled bank has to maintain in liquid assets with BB. The rate was set at 18 percent since 2005. Specialized banks are exempted while banks guided by Islamic laws are required to keep reserve at the concessional rate of 10 percent.

The objectives of SLR are:

Value and Formula The quantum is specified as some percentage of the total demand and time liabilities (i.e. the liabilities of the bank which are payable on demand anytime, and those liabilities which are accruing in one months time due to maturity) of a bank. SLR Rate = Total Demand/Time Liabilities x 100%

3.3.1 .b Cash reserve requirement (CRR)

The cash reserve requirement (or required reserve ratio or only reserve requirement) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. The reserve ratio is sometimes used as a tool in monetary policy, influencing the country's economy, borrowing, and interest rates. BB requests banks to keep five percent of their demand and times liabilities on account at the central bank. Cash in till is not eligible for the CRR.

Impacts of SLR & CRR Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) for scheduled banks are the other monetary policy tools, used sparingly in situations of drastic imbalances from major shocks.
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Lending channel: If SLR Bank lending Bank investment that will Y (output). Cash flow channel: If SLR Cash flow of bank Interest rate Bank investment that will Y (output).

Flow chart-3.2: Trends in SLR & CRR

3.3.2 Discount Rate (Bank Rate):

Bank rate, also referred to as the discount rate, is the rate of interest which a central bank charges on the loans and advances that it extends to commercial banks and other financial intermediaries. Changes in the bank rate are often used by central banks to control the money supply. The rate which central bank lends money to the commercial banks and discounts bill of exchange is called bank rate. If central bank increases the bank rate then the commercial banks will increase their marker of interest rates. As a result the borrowers borrow less form commercial banks and amount of credit reduces in the economy. In an opposite way amount of credit will be increased in the country.
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The discount rate is the rate of interest that Bangladesh Bank charges DMBs for credit. Changes in the discount rate affect the money supply by affecting the volume of discount loans and the monetary base. A rise in discount loans adds to the monetary base and expands money supply. Conversely, a fall in discount loans reduces the monetary base and shrinks money supply. For example, Bangladesh Bank increases the discount rate to money supply. DMBs pay more for Bangladesh Bank credit. Typically, DMBs will increase the lending rate charged from the private sector, and the demand for credit by the private sector will decrease. The current discount rate is 5%.

3.3.3 Open Market Operations:

Open market operations are the means of implementing monetary policy by which a central bank controls the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply. This involves meeting the demand of base money at the target rate by buying and selling government securities, or other financial instruments. Monetary targets such as inflation, interest rates or exchange rates are used to guide this implementation. BB mainly injects or withdraws reserves from the banking system through open market operations (OMO).
For controlling the monetary base, Bangladesh Bank carries out open market operations (OMO). When the central bank engages in open market operations, it buys or sells government securities, bonds in transactions with DMBs. For example, Bangladesh Bank can buy or sell government securities in open market operations to change the quantity of money available. Open market purchases expand the monetary base, thereby raising the money supply. In a repurchase agreement (often called a repo), Bangladesh Bank purchases securities with an agreement that the seller will repurchase them in a short period of time. On the other hand, open market sales shrink the monetary base, lowering the money supply. In a reverse repo transaction, Bangladesh Bank sells securities and the buyer agrees to sell them back to the BB in near future.

This is pursued in two ways: The first type is the outright purchase or sale of approved securities through weekly auctions in volumes consistent with the growth paths for RM and M2 targeted in the annual monetary program. BB injects reserves into the banking system by purchasing approved securities and withdraws reserves from the banking system by selling them. By adjusting the amount and the officially acceptable interest rate at auctions, BB influences the successful bidding rate, and the subsequent public announcement of this rate can convey its intention regarding short term interest rates. For instance, if BB intends to raise short-term interest rates, it increases the scale of its auction in absorbing operations and raises its internally acceptable bidding rate so as to push up the successful bidding rate of the auction and thus mop up excess liquidity from the banking system,
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which influences short-term interest rates. Any significant changes in the interest rate may persuade the stockholders to recalculate their return through dividend discount window and may react accordingly. The second type of Open market operation is a. repo (repurchase agreement) and b. reverse repo auctions. In order to facilitate liquidity management on a day-to-day basis, BB goes for second type of open market operation, either through repurchase agreement (repo) to temporarily add reserves or through reverse repurchase agreements (reverse repo) to temporarily withdraw reserves. Repurchase agreements are essentially short-term loans collateralized by underlying approved securities. BB buys the underlying assets for a given price with an agreement by the selling institution to buy it back at a specified date and price. As the counterpart of repo auctions, BB accepts excess funds from the banks in ascending order of interest rates to the extent needed to 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.

Flow chart-3.3: Trends in Repo& Reverse Repo

3.3.4 Impacts of the Open Market Operations

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Reverse repo and repo interest rates are BBs day to day instruments influencing the growth path of reserve money, ultimately to influence inflation via growth path of broad money. Recently, in the backdrop of the global economic slowdown the routine reverse repo operations are also being used sparingly, to keep credit conditions easy; open market operations seem to be the most effective tool. This is because open market operations are the primary determinants of change in the monetary base. Moreover, they occur at the initiative of the central bank, are easily reversed, and can be implemented quickly.

Part 4 The Concluding Part

4.1 Developing-developed debate on monetary policy

The monetary policy in a developing economy will have to be quite different from that of a developed economy mainly due to different economic conditions and requirements of the two types of economies. A developed country may adopt full employment or price stabilization or exchange stability as a goal of the monetary policy. But in a developing or underdeveloped country, economic growth is the primary and basic necessity. Thus, in a developing economy the monetary policy should aim at promoting economic growth, the monetary authority of a developing economy can play a vital role by adopting such a monetary policy which creates conditions necessary for rapid economic growth. Monetary policy can serve the following developmental requirements of developing economies like Bangladesh.

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, 25

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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