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. Real Sector Economy Financial Sector

The real sector is dealt with by many ministries, while ministry of finance and central bank deal with the financial sector Real Sector Economy Financial Sector Ministry of: Agriculture, Industries Energy and natural resources Commerce Communic ations Water resources Etc. Ministry of Finance, Bangladesh Bank

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) GDP (Y) Output of the Economy Money (MV) When Y  P  and When MV  P 

In Bangladesh the relationship is weak and is not co-integrated. (Ref: Tobin)

Targets of Monetary Policy  Inflation targeting (NZ),  Interest rate targeting,  Exchange rate targeting,  Etc. In Bangladesh we target Quantity of Money in accordance to the Government targets of GDP growth rate and inflation rate.

In targeting quantity of money, how we determine the right quantity of money? PY = y 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

Equation of Money demand with money supply  M d = M s If M d < M s then inflation In log term, M d = b 0 + b 1 GDP + b 2 expected inflation. M d = GDP expected inflation. Statistical properties including ADF and Johanson co-integration tests are OK.

Instruments to control money supply  Bank Rate  Reserve requirements (SLR/CRR),  Open Market Operation (repo, reverse repo, T-bills, BB-bills)  Open Mouth Operation (moral suasion).

Definition of Money Supply: Who Creates Money  M1 = C + DD ……. Liquid, Means of Payments  M2 = C +DD+TT… Not Instantly liquid  M3 = large negotiable deposits, repurchase agreements (USA), deposits of other financial institutes (Bangladesh) C = notes and coins Source of C are: Central Bank and Government Why Treasury (Gov.) Creates Currency? Chapter 13

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, i D, r R, σ) Interest rate, discount rate, required reserve, uncertainty

It is easier to target Reserve Money than to target Money Supply M/H = mm M = mm.H H = High powered money M = Money supply and mm =money multiplier which is assumed to be constant. Chapter 14

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, i D, r R, cu, σ)  Equilibrium mm((i, i D, r R, cu, σ) = L(i, Y)

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)(2)(3)(4) Changes in real money supply Portfolio adjustme nts lead to a change in asset prices and interest rates 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.

Under developed Financial Market and NPL The BB's capacity to implement monetary policy is constrained by the nature of the financial market, which is yet to develop.

Programmed and Actual Reserve Money

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: GDP growth rate 4.8 percent, Inflation 7.06 percent GDP growth rate 5.6 percent, Inflation 4.40 percent

Interest rates and Exchange rates were floated  Interest rates were floated in early 1990s  Exchange rate was floated in 2003.

Movement of Taka against USD

Lending Rates: All Banks

Present 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, BB- bills 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

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