How monetary policy shapes the economy

Bangladesh Bank has just announced the monetary policy statement for the financial year 2022-23 (FY23.)

The coming year will be particularly difficult due to rising inflation and difficulties in the foreign exchange market in Bangladesh.

This article is not about the current situation in Bangladesh, but rather about how a central bank goes about regulating the economy.

We will, however, briefly discuss what appears to be the procedure for setting and implementing monetary policy in Bangladesh.

Two other articles will explore monetary policy in more detail.

One will discuss how monetary policy has worked over the past fiscal years, and the third will review monetary policy in fiscal year 23.

Monetary Policy

The two key concepts are the inflation rate (rate of price increase) and some measure of the economy’s spare capacity, 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 gets to fully utilized capacity, the higher the rate of inflation.

Alternatively, the more unused capacity, the lower the inflation rate.

This makes sense: when the economy is operating near capacity, labor will be able to demand higher wages; there is a greater chance that a shortage of an input will lead to an increase in the price of the input and, ultimately, in the price of goods at the retail level.

On the other hand, when there is a lot of spare capacity, there will be unemployment and less pressure on wages.

Difficulties in the supply chain are less likely to occur.

Inflation will therefore be lower.

According to most central banks, this relationship between capacity utilization and inflation holds in the short term.

Monetary policy focuses on deciding which combination of capacity utilization and inflation to select.

If you want to reduce inflation, you need to account for more spare capacity in the economy.

If you want to increase capacity utilization, prices will increase. We can’t have everything we want.

If you choose a level of capacity utilization, the dynamics of the economy will produce the rate of inflation.

This relationship between unemployment (a measure of spare capacity) and price or wage inflation is called the Phillips curve.

There are many arguments about the existence of the Phillips curve, but conceptually it is on the minds of most major central banks, at least in the short term.

In the longer term, business and consumer inflation expectations cancel out this relationship between inflation and capacity utilization.

If expected inflation is higher than actual inflation, actions will be taken by households and businesses to ensure that the inflation rate will rise and spare capacity will fall.

These actions could be an increase in stocks [what is called by some hoarding, but is a rational response to the expectation of increasing prices] or requests for salary increases to cover anticipated inflation.

When expected inflation equals actual inflation, the link between capacity utilization and inflation is effectively destroyed.

Unemployment will settle at a rate compatible 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 because inflation expectations follow actual inflation.

The amount of slack will decline, but inflation does not respond to monetary policy instruments.

Attention to this trade-off between capacity utilization and inflation is typical of the Federal Reserve’s approach in the United States.

However, many believe that inflation expectations will always be fairly accurate, so monetary policy will not work and focus only 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 set by the central bank.

This is the interest rate that a central bank sets to lend for short periods to commercial banks, with government securities held by the commercial bank as collateral as collateral.

If this rate is lowered, the commercial bank will borrow money from the central bank, which will increase its bank reserves and generally increase lending to businesses.

Competition among banks will tend to lower lending rates and encourage borrowing.

If the rate is raised, this tends to discourage borrowing to increase central bank reserves and raise lending rates, which in turn squeezes business loans.

The Bank of Bangladesh policy rate is called the repo rate.

Also, the central bank can influence the interest rate and the availability of funds by buying and selling government securities.

The Bangladesh Bank’s approach is different.

The analysis assumes a certain GDP growth target and a certain target inflation rate.

These are used to calculate what the rate of increase in the money supply should be, in accordance with these goals.

The money supply can be changed by increasing private sector lending; the variation in credit is made possible by variations in the key rate.

Therefore, if the money supply is not growing fast enough to meet the targets, the Bangladesh Bank reduces the policy rate and the banks find it more attractive to borrow from the central bank by increasing the reserves held in the central bank by the bank. commercial.

This allows the commercial bank to increase lending to the private sector.

The central bank can also increase borrowing by private companies by buying government securities from commercial banks.

This increases bank reserves allowing the commercial bank to lend more.

When a commercial bank grants a loan, it creates a deposit that the private company can use in its operations; the commercial bank must hold reserves with Bangladesh Bank at the level of the prescribed cash reserve requirement as a percentage of deposits.

If the commercial bank wants to make a loan but does not have the reserves, it borrows from the Bangladesh Bank, the deposits will eventually increase and it can repay the central bank.

It should not be thought that the commercial bank has a pot (deposits) and that it makes loans from this pot.

Silver

There are many definitions of money, but Bangladesh Bank defines, for monetary policy purposes, M2 as money in circulation outside banks + deposit accounts including term deposits.

This measures the resources available to the public to buy transactions.

The central bank can control the money supply with some precision.

They don’t always do it, but they can.

Bangladesh Bank finds it difficult to control the money supply if there is an unexpected large change in foreign exchange reserves or if there is a large change in expected government borrowing from the banking sector.

Inflation

Inflation is an increase in prices.

For a small open economy, prices can increase in several ways:

The government spends more than it can collect in taxes; it borrows money from commercial banks or the central bank to finance the deficit.

As he spends that money, businesses and workers receive the money and in turn spend it.

Increased purchases will raise prices unless the increased demand can be imported without forcing a depreciation of the currency or if there is unused productive 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 the currency to depreciate, adding to the higher price of imports in Taka.

Workers demand higher wages, which drives up the price of goods if wages grow faster than productivity growth.

However, we expect prices to be the same as in international markets except for taxes imposed on imports and transportation costs.

Exchange rate

Imported goods will be more expensive if the value of the Taka drops.

The behavior of the exchange rate depends on the system put in place by the central bank. Import prices are linked to world prices in dollars.

The government can subsidize prices so that the retail price is lower than the import price, thereby reducing domestic prices.

The Bangladesh Bank can sell dollars to make the Taka stronger and reduce all import prices.

Inflation is linked to the exchange rate in two ways.

Dollar import prices are rising for all sorts of reasons; the exchange rate depreciates so all imported products become more expensive.

Unused capacity

The simplest measure of spare capacity is the unemployment rate.

The lower the unemployment rate, the less spare capacity there is.

In advanced economies, the unemployment rate is the most frequently used measure of spare capacity.

This is relatively easy to measure and is estimated monthly or quarterly.

To be a valid measure, most of the workforce must be in the formal sector.

Where there is a large informal labor market, the concepts of employment and unemployment are not as well defined.

Other measures are more abstract.

Various efforts are made to estimate capacity metrics, 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 it’s not very clear.

Is it possible to include overtime? Or multiple shifts.

Even if we can clear up the conceptual issues, the task of covering all the 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 served as the first chairman of AmCham and was a consultant for the Bangladesh Bureau of Statistics.

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