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A Theoretical Picture Of Monetary Policy

Definition of Monetary Policy


Monetary policy is the term used by economists to describe ways of managing the supply of
money in an economy.
The actions of a central bank, currency board or other regulatory committee that determine the
size and rate of growth of the money supply, which in turn affects interest rates. Monetary policy
is maintained through actions such as increasing the interest rate, or changing the amount of
money banks need to keep in the vault. (By Geoffrey St. Marie,2011)
Monetary policy includes all monetary decisions and measures irrespective of whether their aims
are monetary and non-monetary, all non-monetary decision and measures that aim it affecting the
monetary system.( Paul Einzig, 2008)
Monetary policy employing the central banks control of supply of money as an instrument for
achieving the objectives of general economic policy. (Harry G. Johnson,2008)
Monetary Policy: Bangladesh Experience
Background of monetary policy in Bangladesh
The policy adopted by the central bank for control of the supply of money as an instrument for
achieving the objectives of general economic policy. As stated in the Bangladesh Bank order
1972, the principal objectives of the countries monetary policy are to regulate currency and
reserves. To manage the monetary and credit system; to preserve the par value of domestic
currency ; to promote and maintain a high level of production, employment and real income ;
and to foster growth and development of the countrys productive resources in the best national
interest. Although the long term focus of monetary policy in Bangladesh is on growth with
stability, the short term objectives are determined after a careful and realistic appraisal of the
current economic situation of the country.
With the shift of the policy stance of the government in various phases, necessary adjustments
were made in the countrys monetary policy in the first year after liberation, the primary target of
monetary policy was to regulate not the quantity of money, but the direction of the flow of
money and in support of the government financial programmed. In 1975, Bangladesh entered in
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to a standby-arrangement with IMF and the countrys monetary policy got a changed shape,
which fixed an explicit target to save limit of monetary expansion on annual basis, with this
change, Bangladesh Bank started setting short-term objectives of monetary policy in close
collaboration of the government and tried to achieve the target by using the direct instrument of
control. The principal target of monetary control was broad money (M2) i.e. , the sum of the
currency in circulation and the total deposits of money in banks. The targeted growth of M2
depended on a realistic forecast of the growth rate of real GDP, an acceptable rate of inflation
and an attainable level of international reserve.
Bangladesh Bank took majors to monitor credit and monetary expansion keeping in view the
price situation and international reserve position. Efforts were made to achieve the targeted
growth of domestic credit and thereby, the money supply, through imposing ceiling on credit to
the government, public and private sector. The major policy instrument available to Bangladesh
Bank and provide liberal refinance facility at confessional rate for priority lending. According to
the national economic policy, the Banks were to provide the desired volume of credit t and
administered and low rate of interest. In that situation, Bangladesh Bank practically did not have
any effective instrument for making adjustment in the growth of money supply or for
transmitting market signals into changes in money supply. The monetary policy therefore, could
not function in true sense as a result the banking system could not play its role as an effective
financial intermediary. (Central Banking in the New Millenium. Ahluwalia,)
Strategy of Monetary Policy in Bangladesh
The MPS (Monetary Policy Statement) starts with expression of the monetary policy frameworks
in terms of the goals, instruments, and the channels of transmission. Maintaining price stability
while supporting the highest sustainable output growth is the stated objective of monetary
policies pursued by the Bangladesh Bank. (http://www.scribd.com )
Frameworks of Bangladeshs Monetary Policy
The framework of monetary policy in Bangladesh set out below

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a) The Policy Target


In this backdrop it is necessary that the monetary policy framework (in terms of the goals, the
instruments, and the analytic channels of transmission) be articulated for greater clarity and
transparency benefiting both the policy makers as well as the stakeholders. A policy system,
where the goals are transparent and their achievement verifiable, directly adds to the credibility
of the central bank, a major objective of this document is to define such a framework. Most
industrial economy monetary policy is run with the task of keeping watch on both the output gap
(i.e., the deviation of actual output from its long-run equilibrium level) and the inflation gap,
which is similarly defined. In contrast, however, the challenge in the developing world is how to
augment the capacity output through both productivity growths as well as via the installation of
additional capacity.
Faster growth in most developing contexts is necessary to reduce (and eventually eliminate)
common poverty. Hence the appropriate monetary policy strategy in the Bangladesh context
would be to achieve the goal of price stability with the highest sustainable output growth. Any
monetary stimulus to promote growth must keep in perspective the broader goal of
macroeconomic stability, which is a prerequisite for future growth. Price stability would also
include the stability of the currency regime.
While fiscal policy too is relevant in addressing these goals and thus there is a need
for policy coordination, monetary policy must play its due role. While leading central banks in
the industrial world have increasingly adopted the unitary goal of fighting inflation, interestingly
directive by enumeratingi)The promotion of price stability.
ii) Ensuring full employment.
iii) Supporting global economic and financial stability (so long as the latter maybe targeted
without prejudicing the first two goals) as the chief monetary policy goals.
In broad terms therefore the latter view is consistent with the BB vision as enunciated above,
although anchored along different perspectives.

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b) Inflation Target
It is the general wisdom that monetary policy tools are of immediate influence in controlling
inflation. However contemporary evidence amply illustrates that monetary policy cannot deal
well with the inflationary impact of external shocks such as the recent international price of oil
and related energy products. Many central banks as a consequence focus on the core inflation,
which is typically constructed by subtracting the most volatile components (e.g., food and energy
prices, indirect taxes etc) from the consumer price index (CPI). The Bank of Canada argues that
it is the core concept that better predicts the underlying price stability in the economy. Hence as a
policy goal, core inflation may be a more credible target than CPI inflation. While there is no
standard measure of core inflation in the Bangladesh context at this time, the construction
methodology is made complex by two facts. First is that food items constitute nearly 60 percent
of the CPI index, and while the appropriate commodity group weights may require a re-think, to
ignore food entirely in defining the core inflation may render the construction a bit like throwing
the baby away with the bath water. Secondly, in the Bangladesh context, the volatility of the
international energy prices appear not to filter down to the CPI since the relevant domestic prices
are subsidized by the state. Periodic adjustments in administered energy prices have always
lagged the world market changes in both the time line as well as in magnitude often most
dramatically. While it may be useful to focus on the non-food component of the index (which
occupies only 41.6 percent of the full CPI) in order to gauge at the build-up of underlying
inflationary forces in the economy, it would be unwise to treat this alone as a valid measure of
core inflation.
c) Growth target
GDP growth projections of the Medium Term Macroeconomic Framework (MTMF) in the
governments National Strategy for Accelerated Poverty Reduction (NSAPR), modified
appropriately in the light of unfolding actual developments, are used as output growth targets for
the purpose of monetary policies.
(National Policy Forum Dhaka: 20-22 August, 2009 Organized by: Centre for Policy Dialogue,
Prothom Alo, The Daily Star,)

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Instruments of Monetary Policy in Bangladesh


In 1989, the government adopted a comprehensive Financial Sector Reform Programmed
(FSRP), following which the countrys monetary policy assumed a new orientation towards
promotion of market economy in a competitive environment. Bangladesh Bank started moving
away from direct quantitative monetary control to indirect methods of
Monetary management since the beginning of 1990. Although, the fixation of target continued to
remain as the central piece of exercise, the way to achieve it had been changed. Credit ceilings
on individual banks and direct controls of interest rates were withdrawn. At present, the money
supply is regulated through indirect manipulation of reserve money instead of credit ceiling.
Major instruments of monetary control available with Bangladesh Bank are the bank rate, open
market operations, rediscount policy, and statutory reserve requirement.
The methods of credit Control
The methods of credit control can be classified as follows
Quantitative Methods
i)Bank rate policy
ii)Open market policy
iii)Variation of reserve ratio
Qualitative Methods
i) Rationing of credit
ii) Direct action
iii)Regulation of consumers credit
iv)Moral persuasion
v)Publicity

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The methods of credit control are described below

Quantitative Methods
The methods by which Central Bank controls the total amount of credit in the economy are
termed as quantitative methods of credit control.
a)

Bank rate policy

The rate which central bank lends money to the commercial banks and discounts bill of exchange
is called bank rate. If central bank increases the bank rate then the commercial banks will
increase their marker of interest rates. As a result the borrowers borrow less form commercial
banks and amount of credit reduces in the economy. In an opposite way amount of credit will be
increased in the country.
Effects
Effects on price level: If bank rate increases, cost of credit will increase and the businessmen
will reduce their borrowing s form commercial banks. This will reduce production and increase
unemployment in the economy. As a result, income and price level will go down and depression
in business and trade will be the outcome. If there is a decrease in the bank rate the opposite e
results of above will be experienced in the economy.
Effects on foreign trades: An increase in bank rate wills increases other interest rates in the
country. So, investment will be profitable. It will ensure the insertion of foreign capital into the
economy and leakage of domestic capital will be stopped. Moreover, increased bank rate will
decrease the piece level because amount of credit will be reduced into country. This decreased
price level will again encourage expert and discourage import, which will make balance of
payment favorable. Opposite effects of above will be experienced if the central bank decreases
the bank rate in the economy.
Limitations of Bank rate policy

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i) Bank rate policy would not be effective if there lacks strong linkage between bank rate and
market/ interest rate especially for a developing country like Bangladesh.
ii) If commercial banks have excessive money; then bank rate may not be effective because they
will lend in lower interest rates though bank rate increases.
iii) Bank may successes during the time of prosperity. Because businessmen become highly
ambitious of their profits in this situation and will borrow money though the interest rate
increases.
iv) Reduction in bank rate may not be successful to increase the amount of credit during the time
of depression. So, bank rate policy has several limitations in its

operation. After that it is

the best weapon of central bank to control the amount of credit in the economy.
b)

Open market policy

The method by which the central bank controls the amount of credit by selling and buying
government credit instrument is termed as open market operation. When the central bank intends
to contract credit, it sales the credit instruments in the market. These instruments are purchased
by commercial banks and people also buy them issuing cheque to the commercial banks. Thus
money goes to the central bank and amount of money for credit creation reduces which in turn
contracts the amount of credit in the economy.
Limitations of open market policy
i) Selling- it reduces amount of cash of commercial banks .but if commercial banks take loan
form central bank it would not be effective to reduce credit.
ii) Buying- it increases the amount of cash in commercial banks. But it may not be able to
expand credit if commercial banks repay loan to the central bank with this increased cash.
iii) Depreciation- During depreciation credit expansion through purchasing credit instruments is
not possible. Because in this period businessmen will not want tomorrow from commercial bank.
c)Variation of reserve ratio
Each commercial bank has to keep legally a certain portion of its total deposits as reserve with
central bank. This is called reserve ratio. If central bank increases this reserve ratio, excess
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reserve in commercial banks will reduce and thus credit creation will be contracted in the
economy. In an opposite way central bank can increase the amount of credit by decreasing the
reserve ratio.

Limitations
i) Increase in reserve ration can be effective for that commercial bank having small amount of
cash. Because bank having large volume of cash will have sufficient excess reserve to create
credit though reserve ration increases. In this case it will not be effective.
ii) Decrease in reserve ration may not be effective to expand credit during depression
businessmen are discouraged to borrow in this situation.
iii) Non-scheduled commercial banks are out of this control.
Qualitative Methods
The methods used to control credit in special sectors for special purposes are called
qualitative\selective methods of credit control. These methods do not deal with the amount of
credit rather change the flow or direction of credit used in different sectors of economy.
a) Rationing of credit
Rationing of credit means fixing the amount of credit among different sectors of the economy.
By this method central bank can decrease the amount of credit in one sector and can increase it in
other sector. For example, if central bank thinks that there is excessive investment in garments
industry and jute industry suffers form required investment, then it can order the commercial
banks not to disburse credit beyond required amount in garments industry and divert the excess
amount to jute industry.
Limitations
i) Borrowers may use the credit money in other purposes.
ii) It is difficult for central bank to supervise whether the credit money is being used purposively
or not.

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iii) Sometimes commercial banks think this type of work as an unwanted intervention by central
bank.
b) Direct action
If it is proved by central bank that credit creation policy of any commercial bank is not
transparent then central bank can take punitive measures against that bank and thus affects its
credit creation. These punitive measures may be of not rediscounting bills of exchange,
discounting bills of exchange at a rate higher than the prevailing rare, etc. As a result, the
commercial bank will compelled to follow sound central bank policy.
c) Regulation of consumers credit
It is a method to control credit in consumable goods, which are purchased in installment basis.
If central bank circulates to increase the amount of down payment or reduce the number of
installment then consumer credit will be contracted in the economy. In an opposite way
consumers credit can be increased. It was followed in USA during Korean War.
d) Moral persuasion
To make the banking system sound and efficient, central bank sometimes requests the
commercial banks to increase or decrease credit. As a guardians request, commercial banks
follow it and thus amount of credit is controlled in the economy.
e) Publicity
Sometimes central bank applies publicity as a weapon of credit control. Central bank
publishes weekly, fortnightly or monthly bulletins and annual reports where balance sheets
and other business and economic condition of different commercial banks are presented well.
As a result the commercial banks become more careful in the line of their credit creation.
Thus central bank applies various types of measures to control credit in the economy. But
central bank should apply different types of method simultaneously rather to use single
method to make credit control effective. ( Bangladesh Bank Working Paper Series: WP 0708,
2007)
Challenges, Recommendation &Conclusion
Key Challenge for Monetary Policy of Bangladesh
The challenges of monetary policy in Bangladesh are as follows
1. There Exist a Non-Monetized Sector

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In Bangladesh there is a existence of non monetized economy in large extent people areas
where many of the transaction are of the barter type and not monetary type .similarly ,due to
non monetized sector the progress of commercial banks is not up to mark ,this creates a major
bottleneck in the implementation of the monetary policy in Bangladesh.

2. Excess Non Banking Financial Institutions (NBFI)


As the economy launch itself into a orbit of economic growth and development, the financial
sector comes up with great speed as a result many non banking financial institutions (NBFI)
come up ,these NBFIs also provide create in the economy ,however the NBFIs is do not come
under the purview of a monetary policy and thus nullify the effect of a monetary policy.
3. Existence of Unorganized Financial Markets
The financial markets help in implementing the monetary policy ,in many developing
countries the financial markets especially the money markets are of an unorganized nature
and in backward conditions ,in many places people like money lenders ,traders ,and business
actively take part in money lending ,but unfortunately they dont not under the purview of a
monetary policy and creates hurdle in the success of a monetary policy
4. Higher Liquidity Hinders Monetary Policy
In rapidly growing economy the deposit base of money commercial bank is expanded, this
creates excess liquidity in the system .under this circumstance even if the monetary policy
increase the CRR or SLR, it does not deter commercial banks from credit creation ,so the
existence of excess liquidity due to high deposit base is a hindrance in the way of successful
monetary policy.
5. Money Not Appearing In an Economy
Large percentage of money never comes in the mainstream economy, rich people, traders
,business and other people prefer to spend rather than to deposit money in the bank ,this
shadow money is used for buying precious metals like gold silver ,ornaments ,and land and in
speculation ,this type of lavish spending give rise to inflation trend in mainstream economy
and the monetary policy fails to control it.
6. Time Lag Affects Success of Monetary Policy
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The success of the monetary policy depends on timely implementation of it ,however ,in
many cases unnecessary delay is found in implementation of the monetary policy ,or many
times timely directives are not issued by the central bank , then the impact of the monetary
policy is wiped out.

Bibliography
Books & Journals
1. Bangladesh Bank, Monetary Policy Statement, January, 2007 to 2008
2. Akram, Tanweer; Bangladeshs Privatisation Policy, Journal of Emerging Markets,
Volume 4, No. 2, Centre for Global Education, New York, USA, 1999.
3. Annual Report of Bangladesh Bank on Monetary Policy 2009 to 2011
4. General Banking by L.R. Chowdhury.
Websites:
1. http//www.bangladesh-bank.org
2. http//www.mtb.com.bd
3. http://ec.europa.eu/economy_finance/publications
4. www.cpd.org.bd
5. http://www.imf.org

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