The ABC of monetary policy

Bangladesh’s monetary policies are framed by Bangladesh Bank, keeping in view the macroeconomic factors such as inflation, economic growth, employment, the balance of payment, and poverty alleviation. Monetary policy is designed to support the government’s policies and programmes, in pursuit of faster inclusive economic growth and poverty reduction while maintaining price stability. The concept of monetary policy is to control the quantity of money in circulation and the channels by which new money is supplied. By managing the money supply, a central bank aims to influence macro-economic factors, including inflation, the rate of consumption, economic growth, and overall liquidity.

The major objectives of the monetary policy of Bangladesh have been outlined in the Bangladesh Bank Order of 1972. The order outlines the major objectives of Bangladesh’s monetary policies, which comprise the goals of achieving price stability, maintaining a high level of production, employment, and economic growth. The monetary policy framework identifies a logical, sequential set of actions for designing and conducting monetary policies. The framework is based on credible information on the stability of money’s demand function, the money supply process, and monetary transmission mechanism. The monetary policies have a number of instruments through which the Bangladesh Bank implements the monetary policies. They are variations in bank rates, the REPO rate and other interest rates, open market operation, selective credit controls, and variations in reserve ratio.

Bangladesh Bank follows two types of monetary policy. They are contractionary and expansionary policies. In developing countries, monetary policies suffer from certain limitations. Due to the unrecognized nature of the money market and lack of integration with the central bank, the traditional method of credit control like bank rate policy, open market operations, and verification of the reserve ratio has limited effect. A government may give a specific target to achieve a certain rate of inflation, say 2 percent. The central bank applies instruments to achieve the target. It might use interest rates or the money supply. In practice, the operation of monetary policy poses a number of difficulties for the central bank.

One problem is that the links up different monetary variables such as interest rates and money supply are uncertain. Some economists argue that concepts such as the credit multiplier are of little use today to policymakers because the value of credit multiplier changes from month to month depending on how easy banks are finding it to borrow and lend money. Certainly, the credit multiplier is of little interest to policymakers if they do not attempt to control the banking system’s volume of high-powered money. So the link between monetary and real variables can also be uncertain. Any type of policy, whether fiscal or monetary or any other is limited in its effectiveness by uncertainty. For instance, the oil price shocks of 1973-74, 1978-79, the stock market crash of 1987, and the Asian crisis of 1997-98 had significant effects on Western economies. But these events could not have been predicted by policymakers. So the economy can be blown off course by an external event outside of the control of policymakers. Further, the economic data is often imperfect. Data collected today are often revised as further data are accumulated.

At times confusion arises regarding monetary and fiscal policies. These two are the same to many, but in reality, their operational areas are different. Monetary policy deals with achieving macro-economic policy objectives such as price stability, full employment, economic growth, and balance of payments. In contrast, fiscal policy deals with tax policy and government spending policy. Monetary policy impacts money supply in the economy, influences interest rates, inflation rates, business expansion, net exports, employment rates, cost of debt, relative costs of consumption versus savings, impacting aggregate demand.

In the backdrop of the ongoing Covid-19 pandemic, the current monetary policy evaluated the existing macro-economic conditions, including the monetary market, foreign exchange market, capital market, prices, and sector development, before adopting to present monetary and credit programmes and policy stance. Various economic indicators suggest that monetary and credit policy for the current financial year need to ensure flows of funds to all productive sectors to general investment and employment to support, government’s economic policies to maintain price stability even during the devastating pandemic, to support survival of vulnerable sectors such as small businesses including tourism, hotels, restaurants, transportation, private schools and training institutes. The prudent policy is to prevent misuse of funds and support new investment and employment generation.

The current monetary policy’s proactive stance shall arrest the deterioration of aggregate demand, streamlining fund use. The current monetary policy has enough space for money and credit growth to support the projected nominal GDP. The projected GDP growth has been targeted at 7.2 per cent and CPI’s average inflation to 5.3 per cent. The velocity of money has declined during financial year 2019-20 and financial year 2020-21 due to slow down of economic activity and high demand for holding cash. Bangladesh Bank’s projection money velocity may fall further during FY 22 due to Covid-19 infected economy. As a result, M2 growth would be more significant than nominal GDP growth. Bangladesh Bank might use it as a monetary policy instrument along with available open market operational tools to control RM growth, imparting broad money growth.

World output is projected to grow by 4.9 per cent, surpassing IMF’s projected target of 4.4 per cent because vaccines will be accessible to all vulnerable low-income economies by mid-2022. But there is a high degree of uncertainty as the new variant Omicron is spreading very quickly. However, faster recovery by the US and EU may build up certain inflationary pressure and could raise interest rates earlier than expected. Emerging economies with slower economic recovery or limited access to vaccines may face daunting challenges.

The writer is former Director General of EPB. He can be contacted at [email protected]