The Bangladesh Bank has just announced the monetary policy statement for fiscal year 2022-23 (FY23.)
This coming year will be particularly difficult due to the rising inflation and the difficulties of the foreign exchange market in Bangladesh.
This article does not deal with the current Bangladesh situation but rather sets out how a central bank goes about regulating the economy.
We will however, discuss briefly, what appears to be the procedure for establishing and implementing monetary policy in Bangladesh.
Two more articles will explore monetary policy further.
One will discuss how monetary policy worked in past financial years and the third will examine the FY23 monetary policy.
Monetary policy
The two key concepts are the inflation rate (rate of price increase) and some measure of unused capacity of the economy, for example, the unemployment rate.
The central bank wants the economy to operate at full capacity and the inflation rate to be low.
However, the closer the economy comes to having capacity fully used, the higher the inflation rate.
Alternatively, the more unused capacity there is, the lower the inflation rate.
This makes good sense: when the economy is operating close to full capacity, labour will be able to demand higher wages; there is a greater chance of a shortage of an input causing the price of the input to rise and ultimately the price of the goods at retail level.
On the other hand when there is plenty of spare capacity there will be unemployment and less pressure on wages.
Difficulties in the supply chain are less likely to occur.
Hence, inflation will be less.
This relationship between capacity use and inflation most central banks believe holds in the short run.
Monetary policy focuses on the choice of what combination of capacity use and inflation to select.
If you want to lower inflation you have to allow for more unused capacity in the economy.
If you want to raise capacity use, then prices will increase. One cannot have everything that one wants.
If you choose a level of capacity utilization then the dynamics of the economy will produce the inflation rate.
This relationship between unemployment (measure of capacity unused) and inflation of prices or wages is called the Phillips curve.
There is a lot of argument about the existence of the Phillips curve, but conceptually it is in the minds of most major central banks at least in the short run.
In the longer run the expectations of inflation held by businesses and consumers undo this relationship between inflation and capacity use.
If expected inflation is greater than actual inflation then actions will be taken by households and companies that assure the inflation rate is going to rise and so unused capacity will fall.
These actions might be increased inventories [what is called by some hoarding, but is a rational response to the expectation of increasing prices] or demands for wage increases to cover expected inflation.
When expected inflation equals actual inflation then the linkage between capacity utilization and inflation is effectively destroyed.
Unemployment will settle at a rate consistent with constant inflation.
But inflation can have any value.
One result is that if a central bank tries to reduce inflation in small steps it will fail as expectations of inflation keep up with actual inflation.
The magnitude of unused capacity will decline but inflation does not respond to the instruments of monetary policy.
Attention to this tradeoff between capacity use and inflation is typical of the approach of the Federal Reserve in the United States.
However, many believe that expectations of inflation will always be quite accurate, so monetary policy will not work and one should just focus on controlling inflation.
This is the position of the European Central Bank.
Unused capacity would be managed by fiscal policy.
The basic instrument for controlling inflation is the level of a risk free interest rate that the central bank sets.
This is the interest rate that a central bank establishes to lend for short periods to commercial banks, with government securities held by the commercial bank as security as collateral.
If this rate is lowered then the commercial bank will borrow money from the central bank increasing its bank reserves and usually will increase lending to businesses.
Competition among banks will tend to lower the lending rates and encourage borrowing.
If the rate is raised then it tends to discourage borrowing to increase reserves from the central bank and raise lending rates, contracting lending to business.
Bangladesh Bank’s policy rate is called the repo rate.
In addition the central bank may influence the interest rate and availability of funds by buying and selling government securities.
Bangladesh Bank’s approach is different.
The analysis assumes some target for GDP growth and some target inflation rate.
These are used to calculate what the rate of increase of the money supply should be, consistent with these targets.
The money supply can be changed by increasing lending by the private sector; the change in lending is made possible by changes in the policy rate.
Hence if the money supply is not increasing fast enough to meet the targets, then Bangladesh Bank reduces the policy rate and banks find it more attractive to borrow from the central bank increasing the reserves held in the central bank by the commercial bank.
This enables the commercial bank to increase lending to the private sector.
The central bank can also increase borrowing by private enterprises by buying government securities from commercial banks.
That increases bank reserves enabling the commercial bank to lend more.
When a commercial bank makes a loan it creates a deposit for the private company to use in their operations; the commercial bank must be holding reserves at Bangladesh Bank at the cash reserve requirement prescribed as a percent of the deposits.
If the commercial bank wants to make a loan but does not have the reserves then they borrow from the Bangladesh Bank, eventually deposits will increase and they can repay the central bank.
One should not think that the commercial bank has a pot of money (deposits) and it makes loans out of that pot.
Money
There are many definitions of money but Bangladesh Bank defines for monetary policy purposes M2 as the currency in circulation outside the banks + the deposit accounts including fixed deposits.
This measures the resources that the public has for buying transactions.
The central bank can control the money supply with some accuracy.
They do not always do so but they have the capability.
Bangladesh Bank experiences problems in controlling the money supply if there is an unexpected large change in foreign exchange reserves or if there is a large change in the expected government borrowing from the banking sector.
Inflation
Inflation is an increase in prices.
For a small open economy, prices can increase in a number of ways:
The government spends more than it can collect in taxes; it borrows money from the commercial banks or the central bank to finance the deficit.
As it spends this money the companies and workers receive the money and in turn spend it.
The increased purchases will raise the prices unless the increased demand can be imported without forcing a depreciation of the currency or there is unused production capacity in the domestic economy.
The dollar price of imports increases due to factors in other countries; this puts pressure on the balance of payments, causing depreciation of the currency, adding to the higher price of imports in Taka.
Workers demand higher wages and this drives up the price of goods if the wages rise faster than productivity growth.
However, we expect prices to be the same as in international markets except for taxes imposed on imports and transport cost.
Exchange rate
Imported goods will be more expensive if the value of the Taka falls.
How the exchange rate behaves depends on the system established by the central bank. Import prices are linked to world dollar prices.
The government may subsidize prices so that the retail price is less than the import price, hence reducing domestic prices.
Bangladesh Bank may sell dollars to make the Taka stronger and reduce all import prices.
Inflation is linked to the exchange rate in two ways.
Import dollar prices rise for all sorts of reasons; the exchange rate depreciates so all imported products become more expensive.
Unused capacity
The simplest measure of unused capacity is the unemployment rate.
The lower the unemployment rates the less unused capacity.
In the advanced economies the unemployment rate is the most frequently used measure of unused capacity.
This is relatively simple to measure and is estimated monthly or quarterly.
To be a valid measure most of the labor force must be in the formal sector.
When there is a large informal labor market, the concept of employment and unemployment is not so well defined.
Other measures are more abstract.
There are various efforts to estimate capacity measures, but there are many problems.
Consider a manufacturing establishment.
There is a concept of the maximum output that can be produced under normal conditions.
But this is not very clear.
Is the capacity to include working overtime? Or multiple shifts.
Even if we can clear up the conceptual issues, the task of covering all different products is extremely difficult.
In Bangladesh there is no clear idea of full capacity.
Instead the GDP announced in the budget represents the target utilization position.
Forrest Cookson is an economist who has served as the first president of AmCham and has been a consultant for the Bangladesh Bureau of Statistics.