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

•Communications

•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)

YMVP

When Y P and When MV P

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

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M2 Growth

Inflation (yoy)

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 = yOr, y(1+Δy)=P(1+ΔP) Y(1+ ΔY)Or, Δy=(1+ΔP) (1+ ΔY)-1Or, 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

Md = Ms

If Md < Ms then inflationIn 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.

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 coinsSource of C are:

Central Bank and Government

Why Treasury (Gov.) Creates Currency?Chapter 13

Reserve Money and Money Multiplier

M = C + D H = C + RDividing by DM/D = cu + 1H/D = cu + recu assumed to be constantre =f(i, iD, rR, σ)

- + + +

Interest rate, discount rate, required reserve, uncertainty

It is easier to target Reserve Money than to target Money Supply

M/H = mmM = mm.HH = High powered moneyM = 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 DM/H = (cu +1)/ (cu + re)M = [(cu +1)/ (cu + re)].HMm = (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) (2) (3) (4)

Changes in real money supply

Portfolio adjustments 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

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Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07

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Actual

Programmed

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 percent2000-2006 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

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Taka p

er 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

Thank You