MONETARY POLICY
FRAMEWORK
Jamshed uz Zaman
Major Divisions of the Economy

If our economy were a circle then
one half of it would be real sector
and the other be Financial sector.
Economy
Real
Sector
Financial
Sector
The real sector is dealt with by many
ministries, while ministry of finance and
central bank deal with the financial sector
Economy
Ministry
of:
• Ministry of
Finance,
Real
Sector
•Bangladesh
Bank
Financial
Sector
•Agriculture,
•Industries
•Energy and
natural
resources
• Commerce
•Communic
ations
•Water
resources
Etc.
Output of the real sector is GDP(Y)
while that of financial sector is money
(MV)

Interaction between the sectors
determine the price level (monetarists
concept)
Output of
the Economy
GDP
(Y)
Money
(MV)
P
When Y P and
When MV P
MV
Y
-10
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
Inflation and M2 Growth have
some relationship in the Long term
50
M2 Growth
Inflation
40
30
20
10
0
In Bangladesh the short term
relationship is weak and is not cointegrated. Lag relation may be.
25
14
M2 Growth
12
Inflation (yoy)
20
10
15
8
6
10
4
5
2
ar
'0
7
Au
g'
07
Ja
n'
08
Ju
n'
08
No
v'
08
Ap
r'0
9
M
Ju
l'0
5
De
c'0
5
M
ay
'06
O
ct
'0
6
Fe
b'
05
0
Ap
r'0
4
Se
p'
04
Ju
n'
03
No
v'0
3
0
20
-5
-10
1974-75
1975-76
1976-77
1977-78
1978-79
1979-80
1980-81
1981-82
1982-83
1983-84
1984-85
1985-86
1986-87
1987-88
1988-89
1989-90
1990-91
1991-92
1992-93
1993-94
1994-95
1995-96
1996-97
1997-98
1998-99
1999-00
2000-01
2001-02
2002-03
2003-04
2004-05
2005-06
2006-07
2007-08
2008-09
2009-10
2010-11
GDP is supply side. In crisis year it
has serious influence
Inflation
GDP Growth
15
10
5
0
-5
-10
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
Inflation
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
1991-92
1990-91
1989-90
30
1988-89
1987-88
1986-87
1985-86
1984-85
1983-84
1982-83
1981-82
1980-81
Pass-through effects
35
%Growth Import Price
25
20
15
10
5
0
-5
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
Inflation
1998-99
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
1991-92
1990-91
1989-90
1988-89
1987-88
1986-87
1985-86
1984-85
1983-84
1982-83
1981-82
1980-81
Exchange rate is a monetary
phenomenon
25
Exchange Rate %Change
20
15
10
5
0
-5
2009-10
2008-09
2007-08
2006-07
2005-06
2004-05
2003-04
2002-03
2001-02
2000-01
1999-00
1998-99
Inflation
1997-98
1996-97
1995-96
1994-95
1993-94
1992-93
1991-92
1990-91
1989-90
20
1988-89
1987-88
1986-87
1985-86
1984-85
1983-84
1982-83
1981-82
1980-81
If any relation, between Indian and Bangladeshi
Inflation, it may be the result of the same cause
Indian Inflation
15
10
5
0
Results found


Looking at these slides it becomes
imperative that in long run inflation
in Bangladesh is mainly caused by
money (??). [Financial deepening,
Gini coefficient – poverty situation
should also be considered]
Can short run monetary policy
stabilize inflation? If not, our target
of the policy should not be inflation.
Targets of Monetary Policy round
the globe
Inflation targeting (NZ),
 Interest rate targeting,
 Exchange rate targeting,
 Etc.
In Bangladesh we target Quantity of
Money in accordance to the
Government (or projected) targets
of GDP growth rate and inflation
rate.

In targeting quantity of money, how we
determine the right quantity of money?
y = PY
Or, y(1+Δy)=P(1+ΔP) Y(1+ ΔY)
Or, Δy=(1+ΔP) (1+ ΔY)-1
Or, ΔM = ξ[(1+ΔP) (1+ ΔY)-1]
Where PY is GDP at current prices and y is
at constant prices. Δ indicates percentage
changes
ξ = ΔM/Δy Income elasticity of money
demand
Monetary Policy Stance of
Bangladesh

The monetary policy –aims
highest sustainable output
growth with reasonable price
stability. For this Bangladesh
Bank prepares ‘Money and
Credit programme and Reserve
money programme’.
Equation of Money demand with money
supply
Md = Ms
If Md < Ms then inflation
In log term,
Md = b0 + b1 GDP + b2 expected inflation.
Md = -11.3 + 2.59 GDP + 0.014 expected
inflation.
Statistical properties including ADF and
Johanson co-integration tests are OK.

Md < Ms


When Supply of Money is more than
Demand for Money, we try to control
money creation.
Who creates money? How to control
them?
Who Creates Money
Definition of Money
 M1 = C + DD [narrow money]
 M2 = C +DD+TD [broad money]
 DD and TD (demand and time
deposits are created by banks)
Who creates :


Central Bank and Government
Why Treasury (Gov.) Creates
Currency?
How to control money

Classical Approach


Control commercial banks
Modern Approach

Control central bank/ control creation
of money/control government
Classical Approach: Instruments to
control commercial banks




Bank Rate
Reserve requirements (SLR/CRR),
Open Market Operation (repo,
reverse repo, T-bills, BB-bills)
Open Mouth Operation (moral
suasion).
Modern Approach: It is easier to target
Reserve Money than to target Money Supply
H = mm.M
H = High powered money
M = Money supply and mm =
multiplier which is assumed to be
constant.
Reserve Money and Money
Multiplier
M=C+D
 H = C + R
Dividing by D
M/D = cu + 1
H/D = cu + re

cu assumed to be constant
re =f(i, iD, rR, σ)
- + + +
Interest rate, discount rate, required reserve,
uncertainty
Supply Side (contd.)
Since,
M/H = (C + D)/(C + R)
Dividing by D
M/H = (cu +1)/ (cu + re)
M = [(cu +1)/ (cu + re)].H
mm = (cu +1)/ (cu + re)
Therefore, M = mm.H
Equilibrium in the Money Market



Demand for Money M/P = L(i, Y)
Supply of Money M/P = mm((i, iD, rR, cu, σ)
Equilibrium
mm((i, iD, rR, cu, σ) = L(i, Y)
Equilibrium and Shift in Curve
Equilibrium and Shift in Curve
Slow and limited response of the policy
initiative is attributable to the following
reasons:
• The transmission mechanism of monetary
policy stance, i.e., how, when and through
which channel the policy initiatives works in
Bangladesh, is still unidentified.
• We have limited information about the
requirement of money needed for financial
deepening and monetization process. This
creates a problem of estimating money
demand.
• Change in Net Foreign Assets is often
exogenously determined and we do not have
sufficient sterilization mechanism.
Transmission Mechanism
(1)
Changes
in real
money
supply
(2)
Portfolio
adjustments
lead to a
change in
asset prices
and interest
rates
(3)
(4)
Spending
adjusts to
the change
in interest
rates
Output
adjusts to
the change
in
aggregate
demand
Necessity of Monetary and Fiscal
Policy Mix



Monetary policy instruments can exert their
influence only on private sector credit, which
explains only a part of total changes in money
supply. This can be explained by the following
equation:
ΔM = ΔCredit to Gov + ΔCredit to other Public
Sector + ΔCredit to Private sector + ΔNet Foreign
Assets + ΔOthers.
In Bangladesh, changes in credit to the
government and to other public sector are beyond
any monetary policy stance. Mainly because of
this Actual level of Money remains at higher level
than the Programmed level at times of fiscal
mismatch.
Slow and limited response of the policy
initiative is attributable to the following
reasons:
• The transmission mechanism of monetary
policy stance, i.e., how, when and through
which channel the policy initiatives works in
Bangladesh, is still unidentified.
• We have limited information about the
requirement of money needed for financial
deepening and monetization process. This
creates a problem of estimating money
demand.
• Change in Net Foreign Assets is often
exogenously determined and we do not have
sufficient sterilization mechanism.
Implementation of Monetary policy
is weak. Authorities efforts..



Underdeveloped Financial Market
Weak sterilization
Difference between programmed
and actual
Under developed Financial Market and
NPL
The BB's
capacity
to
impleme
nt
monetary
policy is
constrain
ed by the
nature of
the
financial
market,
which is
yet to
develop.
Programmed and Actual Reserve
Money
430
410
Billion Taka
390
Actual
Programmed
370
350
330
310
290
270
250
Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07
BB’s Initiatives to Develop Financial
Market
Move towards market based monetary
and credit management
 Improvement in legal and judicial
processes,
 Improvement in prudential regulations
and governance.
 As a result:
1990-1999 GDP growth rate 4.8 percent,
Inflation 7.06 percent
2000-2006 GDP growth rate 5.6 percent,
Inflation 4.40 percent

Monetary Policy: Historical
Development




Since 1990 under FSRP policy shifted from
direct control to indirect control.
Directed lending was abolished and interest
rates were gradually liberalized.
BB introduced its own security 91 -day BB bill
in 1990 and later on 30-day BB bill; and started
to use modern monetary tools like REPO and
reverse REPO in FY03,
Since 31 May 2003 BB has been pursuing full
floating exchange rate system under which the
exchange rate of Taka is determined on the
demand-supply basis.
Monetary Policy: Historical
Development (contd.)




BB has been announcing beginning 2006 half
yearly monetary policy statement (MPS),
Government debt management and monetary
management have been separated in 2007.
Now the Yearly as well as quarterly auction
calendars of government credit are announced
before the start of the fiscal year.
In preparing monetary policy real GDP growth
rate and inflation rate now are not taken as
axioms; rather BB sometimes projects these
variables considering national and global
macroeconomic situation,
Monetary Policy: Historical
Development (Contd.)



Since July 2009, BB intends to include more people
under the umbrella of financial system with a view
to strengthening financial deepening and broadening
financial inclusion. Under this consideration, BB
instructed the banks to allow farmers opening
savings account with only taka 10.
Much more emphasis has been given to strengthen
lending in Agriculture, SME, environmentally
sustainable projects such as bio-gas and solar
energy; and also in new power plant establishment
than before.
Monetary policy and programme are now more
transparent, open, pro-people and inclusive.
14-01-08
06-11-07
28-08-07
27-06-07
24-04-07
18-02-07
12-12-06
05-10-06
02-08-06
04-06-06
29-03-06
24-01-06
17-11-05
08-09-05
19-07-05
29-05-05
04-04-05
08-02-05
13-12-04
14-10-04
23-08-04
03-07-04
Taka per USD
Movement of Taka against USD
75
73
71
69
67
65
63
61
59
57
55
Nominal Lending Rates [What
about real rates]
Monetary Policy Stance






BB is now announcing its monetary policy every
six months.
BB’s policy is to encourage higher and
sustainable growth (by providing credit to
productive sector) with restrained inflation rate.
To achieve this, indirect monetary control
instruments are being used. Crude and direct
methods are avoided.
Repo, reverse repo rates and t-bills/bond, BBbills yield rate are the main policy instruments.
Development of financial sector.
Capacity building in the Bangladesh Bank.
Repo, Reverse Repo, Call Rate
Yield on Treasury Bills
Excess Liquidity
Deficit Financing
Thank You