D.U. Journal of Marketing, Vol. 16, No.

1, June 2013 (Published in December, 2015)

INFLATION IN BANGLADESH: AN ECONOMETRIC

INVESTIGATION

Dr. Haripada Bhattacharjee1

Abstract: Inflation has been one of the pressing economic problems facing
Bangladesh governments since her birth in 1971. Some studies have been
under taken to examine the dynamics of the inflationary process in the re-
gion. These studies have shown that the main factor contributing to the
increase in retail prices over time has been the continual rise in import
prices. Other factors such as wage rate, interest rate, and tax rate increases
have also contributed to the inflationary process. The effects of inflation on
resource allocation and use, the standard of living, and income distribution
necessitate a detailed examination of the causes of inflation so that
measures can be implemented to arrest the process.

INTRODUCTION
This study is an econometric investigation of the causes of inflation in
Bangladesh during the period 1972-2012. Previous studies on inflation did not
employ econometric techniques, and hence the extent to which various factors
affect the rate of inflation was not quantified. First, we outline the inflationary
experience in Bangladesh over the study period. Second, we present a model of
the inflationary process, test it, and assess its forecasting ability. We conclude
with some policy implications of this research and provide suggestions for
further work.

THE INFLATIONARY EXPERIENCE, 1972-2012

Inflation can be considered a dynamic process involving the sustained rate of
increase in the “general price level” over time. We are therefore interested in the
time path of commodity price increases. Three periods of the inflationary path in
the Bangladesh economy can be identified. Between the years 1972 and 1975, the
average annual rate of inflation was 6.99%. During the period 1975-90, the
average annual rate of inflation jumped to 9.8%. The economy experienced a
further dramatic rise in the inflation rate between 1990 and 2012, when the
average annual rate stood at 10.31%.
During 1980s, many developed economies including United States adopted
contractionary monetary measures. The openness and financial dependence of the
economy meant that these increases were transmitted to the domestic money
market. Because of poor performance of nationalized commercial banks with
limited role of central bank, the foreign-owned commercial banks, which

1
Professor, Department of Marketing, University of Dhaka, Bangladesh.
2 D.U. Journal of Marketing, Vol. 16, No. 1, June 2013

monopolized the local money market, were able to increase their loan rates. Since
interest on loans represents a cost to firms, the increase in loan interest rates
contributed significantly to the increase in the annual inflation rate from 0.70% in
1972 to 4.17% in 1975. Further increases in interest rates and the devaluation
were mainly responsible for the rise in inflation from 3.62% in 1977 to 9.24% in
1990. In spite of the wide application of price controls to dampen the effects of
inflation, the effects of the devaluation were still felt in 1990.
The period 1982-92 was marked by “double-digit” inflation rates (from 8.12% in
1980 to 12.71% in 1992). A number of factors contributed to this highly
inflationary period. The early 1970s were marked by a world commodity
shortage that brought significant increases in the prices of agricultural products.
In October 1973, the international oil cartel, OPEC, announced price increases
that brought a quadrupling of the costs of petroleum and related products. The
growth in the money supply in the United Kingdom and the United States
contributed to the growth in international liquidity and hence world inflation.
Freight rates for shipping were increased on account of the rise in the price of
petroleum-thus leading to the rise in the c.i.f. value of imported commodities.
The government increased indirect taxes to take up the revenue slack of the new
tariff structure and also to pay for the increased costs of public operations
brought about by inflation. A 5% sales tax on nonfood items, introduced in 1974,
contributed to the inflationary process. The removal of the legal ceiling on
interest rates and the reduction in government foreign borrowing brought
significant increases in the interest rates on loans within the domestic money
market.

Table 1: Average Annual Increases in Import Prices by Category and

Inflation Rates in Bangladesh, 1972-2012
IMPORT CATEGORIES

Raw Materials IMPORT

Consumer and Capital PRICE INFLATION
PERIOD
Goods (42) Intermediate Goods (28) INCREASE RATES
Goods (30) S

1972-75 4.1 5.84 4.87 7.1 6.99

1975-90 6.1 9.9 8.84 11.87 9.8
1990-2012 12.11 17.54 22.05 15.65 10.31

Source: Calculated by the authors from data obtained from statistical year books of Bangladesh.
Note: Figures in brackets indicate weights.

The above table suggests that the inflationary experience of Bangladesh during
period 1972-2012 conditioned mainly by external factors. The relationship
between increases in import prices and inflation is quite evident (Table 1).
Inflation in Bangladesh: An Econometric Investigation 3

The data indicate that the prices of imported raw materials and intermediate and
capital goods increased more rapidly than the prices of imported consumer goods
over the period. This implies that the indirect effect of import price increases on
the domestic inflation rate dominated the direct effect. Although in 1976 there
was some concern that the widening budget deficit and excessive liquidity in the
banking system might have triggered off new inflationary pressures, in general,
increases in import prices and interest rates on loans have been the main causes
of inflation in Bangladesh.

OBJECTIVES
The paper has three specific objectives:
1. To identify the factors that affect inflation in Bangladesh,
2. To outline the inflationary experience in Bangladesh during 1972- 2012, and
3. To present a model of the inflationary process, test, and assess its forecasting
ability.

METHODOLOGY
The study utilizes secondary data collected from the various issues of Bangladesh
Bureau of Statistics. The study period was 1972 to 2012. All relevant information
was measured in constant term. Effects of price of imported consumer goods and
oil price were the main variables in calculating the inflationary process. The
study proposes a model to measure the inflationary pressure in Bangladesh.

MODELING THE INFLATIONARY PROCESS

In a small, open economy that has a managed exchange rate with its main trading
partner, there are four basic ways in which foreign prices can affect domestic
inflation. The cost-push view focuses on the impact of the prices of imported
commodities on domestic price equations. The demand-pull approach attributes
inflation to excess aggregate demand in the world economy due to monetary
expansion beyond the supply capacity of the world economy. Non-market or
institutional explanations point to the international demonstration effect of trade
union activities and the price-setting behavior of multinational corporations.
Monetary theorists state that the inability of the monetary authorities to sterilize
inflows of foreign exchange leads to an increase in the domestic money supply,
creating stock disequilibrium in the money market and, consequently, inflation.
The inflationary process in a small, open economy such as that of Bangladesh is
fueled by cost-push and institutional factors more than by demand-pull factors.
Excess aggregate demand due to increases in the money supply (or credit
creation) tends to affect the balance of payments rather than inflation in a small,
open economy.
4 D.U. Journal of Marketing, Vol. 16, No. 1, June 2013

Because this paper examines commodity price inflation, it is possible to divide

the commodity market into transactions for tradable and non tradable in order to
obtain a better understanding of the dynamics of inflation. The continual increase
in the prices of imported final consumer goods will have a direct effect on the
domestic rate of inflation. On the other hand, the indirect effect is generated
through the increase in the prices of non-consumer goods. These non-consumer
goods are used as inputs in the production of both tradable and non-tradable. The
demand for such imported inputs arises from the import substitution and export
promotion programs undertaken by the government.
Most cost-push models of inflation tend to focus on the labor cost variable. We,
however, advance the view that wages rise as a result of commodity price
increases rather than the converse. The nature of wage bargaining is such that
workers (or trade unions) seek to catching up with inflation. If wage increases do
influence the inflation rate, this will occur with a lag that varies with the length of
the contractual period.
The cost of credit may influence the rate of inflation. Because interest rate
payments represent a cost to the firm, especially with respect to working capital
requirements, an increase in the loan rate is passed on to the consumer in the
form of higher prices. Evidence suggests that the pricing practices of
oligopolistic firms in the distribution sector, by way of average cost pricing,
condition this loan rate-cost-price relationship.
The government‟s taxation policy may also affect the inflation rate. In order to
finance expenditure programs, government has relied on indirect taxes, especially
customs duties. The incidence of these taxes depends on the values of the
demand and supply price elasticity but, in general, one would expect that the
continuous increases in indirect taxes would affect the rate of inflation. In many
cases, however, the government increases and/or decreases tax rates on various
commodities to lessen their overall impact on the inflation rate.
We have identified cost-push factors that affect the rate of inflation in
Bangladesh. It is possible that demand-pull factors can have some effect on the
rate of inflation where the ratio of non-tradable to tradable is high. In such a
situation, given the nonexistence of excess capacity in production plants, the
increase in aggregate demand for non-tradable can lead to increased prices.
However, this is not the case in Bangladesh, where the ratio of non-tradable to
tradable is low and many production plants operate under conditions of excess
capacity.
If one treats the overall import price index as a weighted average of its
components, then the cost-push inflation model can be summarized in the
following equation:
Inflation in Bangladesh: An Econometric Investigation 5

pt  pt ( pmt , rt , wt i , Ti ; Qt ) (1)
    
where, the percentage change of a variable at time, t, is given as pt, price level;
pmt, import price index; rt, cost of credit; Tt, tax rates vector; Qt, vector of other
factors; and wt-i;, wage rate (at time t-i).
The signs beneath the arguments in equation (1) represent the direction of change
in the dependent variable pt as any one of the independent variables change. A
plus sign indicates a direct relationship and a minus sign an inverse relationship.
It can be shown that equation (1) can be derived from either average cost or
marginal cost pricing principles.

EMPIRICAL ANALYSIS
In order to determine the quantitative relationship between the domestic inflation
rate and import prices, interest rate, and wage rate changes, we undertake a
regression analysis of the data for the period 1972-2012. The inflation rate is
defined as the percentage change in the retail price index (pt), the interest rate
variable is the prime lending rate (rt), while the wage rate variable is an average
earnings index (wt). In this study, we have not considered the explicit effect of
tax rate changes, Tt, and other factors, Qt. The exclusion of these variables
imparts a specification error to our results, but we expect that this will have a
negligible effect on the standard errors of my estimates. If we hypothesize that Tt
and Qt have positive effects on the inflation rate, then their mean effect can be
captured in a positive constant term.
Our regression results indicate that the percentage change in the import price
index (pmt) is the dominant variable in the inflationary process (see table 2). It
accounts for approximately 73% of the total inflation during the study period.
The rate of interest on loans is also a significant variable in the process as
indicated by a high t-statistic. Approximately 85% of the variation in inflation in
Bangladesh can be attributed to the interest rate and import price increases. The
values of the Durbin-Watson statistic indicate that no first-order serial correlation
is present and the insignificance of the constant term provides some indication
that the mean effect of the omitted variables is insignificant. Note that the wage
rate variable is insignificant at the 5% level and its coefficient has the wrong a
priori sign. This indicates that current wage rate changes have little or no
influence on current price changes. As stated earlier, the nature of the wage
bargaining process is such that previous wage increases may influence the
current rate of inflation.
6 D.U. Journal of Marketing, Vol. 16, No. 1, June 2013

Table 2: Inflation in Bangladesh (Dependent Variable P,)

Constant pmt rt wt R2 D-W SEE

2.1 1.83 0.80 .73 1.69 5.05

(1.12) (6.41
2.2 2.24 0.72 0.35 .86 2.15 3.73
(1.85) (7.61) (3.67) .84*
2.3 2.27 0.90 - .14 .75 1.73 5.09
(1.32) (5.17) (- .87)
2.4 2.84 0.86 0.36 - .18 .89 1.90 3.52
(2.36) (7.03) (4.03) (-1.65) .87*
2.5 8.37 0.51 .30 .77 8.16
(4.21) (2.53)
2.6 4.50 .43 .26 1.19 8.37
(1.64) (2.31)

Note.-R = coefficient of determination; * = adjusted R2; D-W = Durbin-Watson statistic; SEE =

2

standard error of the regression (estimate).

We therefore introduce a lagged wage rate variable to capture this relationship.

The estimated equation becomes
P, = 1.31 + 0.69 pmt + 0.39rt + 0.12wt-1, (2)
(0.89) (6.64) (3.81) (1.27)
2
R = 0.85, D-W = 2.13, SEE = 3.78, F = 28.11.
The coefficient of the lagged wage rate variable, wt-1, yields the correct a priori
sign, but it is only significant at the 15% level. Using the adjusted coefficient of
2
determination, R the inclusion of wt-1 only adds 1% to the explanation of
inflation during the period. Our result refutes the claim that wage rate increases
have been a significant factor in the inflationary process. The direction of
causation runs from inflation to wage rate increases. In order to verify this claim,
we regress Pt, rt, and yt on wt, where yt represents the percentage change in real
output (GDP). The ordinary least squares results indicate negative serial
correlation, so we report only the regression obtained by using the Cochrane-
Orcutt iterative estimation procedure:
wt = 4.21 + 0.72pt - 0.02yt - 0.36rt (3)
(1.29) (3.22) (-0.03) (-1.48)
R2 = .47, D-W = 2.05, SEE = 9.31, F = 3.52,  = -.58 (-2.86).
The regression result clearly shows that increases in prices determine increase in
wage rates.
Inflation in Bangladesh: An Econometric Investigation 7

If we employ simultaneous equations model, with pr and wt being endogenous

variables, then the price inflation equation is exactly identified when wt enters pt
and is over-identified by the order condition when wt-1 enters pt. we use both
indirect least squares and two stages least squares estimation procedures but no
better results are obtained.
We also examine the role that inflationary expectations play in the inflationary
process. Adopting the extrapolative thesis that price expectations are based on the
current rate of inflation plus an adjustment based on the trend over the last period
yields
pte  pt   ( pt  pt 1 ) (4)
If  > 0, price expectations will tend to be in the same direction as the trend;  <
0, past trends are expected to be reversed and  = 0 expected and actual inflation
rates are coincidental. Given the inflation equation,
pt  0  1 pmt   2 rt  3 pte  t (5)
αi > 0, i = 0, 1, 2, 3,
then substituting (4) in (5) yields
Pt = β0 + β0 Pmt + β2 rt + β3 Pt-1 + t, (6)
where
β0 = α0/, β1 = α1/, β2 = α2/,
β3 = -α3/,  = µ/,  = 1 - α3 - α3.
Although ordinary least squares (OLS) estimation is not the best procedure for
determining the coefficients of equation (6) because it yields biased but
consistent estimates in small samples, “no other estimation procedure has been
shown to be „better‟ in small samples.” Our OLS results are
pt = 1.58 + 0.64pmt + 0.35rt + 0.16pt-1, (7)
(1.14) (5.31) (3.60) (1.30)
2
R = 0.85, h = -0.21, SEE = 3.76, F = 28.32.
The price expectations variable yields the same result as the lagged wage rate
variable-correct a priori sign and significant only at the 15% level. There is
evidence of multi-collinearity between pmt and pt-1, since the t-statistic declines
significantly with the inclusion of the pt-1 variable. One reason the pt-1 variable
does not play an explicit role in the inflation equation may be its embodiment in
rt. Because the nominal interest rate consists of the real interest rate plus
inflationary expectations, if inflationary expectations are proxied by pt-1,
rt  rt*  pte  rt*  pt 1 , (8)
8 D.U. Journal of Marketing, Vol. 16, No. 1, June 2013

where rt* is the real interest rate. If the money supply is fixed in the short run,
then inflationary expectations will increase the price level within a static IS-LM
framework. The adjustment factor,, cannot be estimated within the above
framework.
2
Because the R indicates that 15% of the inflation is left unexplained, we shall
explore the residuals of table 2 (2.2) and equation (2) to determine points at
which the actual and predicted values of the inflation rate diverge significantly.
We also utilize the inflationary experience outlined in Section II to determine the
reasons for these divergences. We observe that in the periods 1975 and 1990 the
divergences between the actual and predicted inflation rates were significant. In
the period 1990, interest rates were high and devaluation occurred; in 1977-78,
the price of oil and other commodity prices increased drastically. We
experimented with dummy variables to capture the events in these two periods.
We set the dummy variable equal to unity for 1975 and the period 1990 and to
zero for the other years. The following result was obtained:
pt = 1.06 + 0.64pmt + 0.30rt + 6.25Dt (9)
(1.42) (11.12) (5.29) (5.27)
2
where R = .96, D-W = 1.88, SEE = 2.19, and F = 95.14. In this formulation, the
intercept term is affected such that for the years 1975 and 1990, the regression
line would be
pt = 7.31 + 0.64pmt + 0.30rt (10a)
and, for the other years,
pt = 1.06 + 0.64pmt + 0.30rt. (10b)
If one assumes that only the slope is affected by the events in 1975 and 1990,
then
pt = 3.46 + 0.41pmt + 0.23rt + 0.40Dpmt, (11)
(3.01) (2.77) (2.45) (2.47)
2
where R =.91, D-W = 1.96, SEE = 3.20, F = 42.26. For the years 1975 and 1990,
the regression equation is
pt = 3.46 + 0.81pmt + 0.23rt, (12a)
and otherwise the equation is
pt = 3.46 + 0.41pmt + 0.23rt. (12b)
We introduce dummy variables in my equations in light of the view that if
“import prices rose smoothly year by year and took a jump,” with the devaluation
in 1990 and explosion in oil prices in 1973, “then the time shape of the index of
import prices might have been reflected.” As expected, the inclusion of the
dummy variables increases the explanatory power of the equations. Using the
coefficient of determination, R2, it seems that the events of 1975 and 1990 affect
Inflation in Bangladesh: An Econometric Investigation 9

the intercept of the function more than its slope. Although the use of dummy
variables allows me to capture certain institutional features influencing the rate of
inflation, in terms of policy relevance their use is not very enlightening.
In conclusion, our empirical analysis points to the importance of import price and
interest rate increases in the inflationary process within the economy of
Bangladesh. Wage rate changes have an insignificant effect on the inflation. In
terms of the forecasting ability of the model, using table 2 (2.2), the root mean
squared error is 3.33 while the Theil‟s inequality coefficient is 0.134, which both
indicate that my model can yield fairly good out-of-samples estimates of the
inflation rate.

SUMMARY AND CONCLUSION

Our econometric analysis of inflation in Bangladesh, over the period 1972-2012,
indicates that increases in import prices and the prime lending interest rate are the
main determinants of inflation. This conclusion indicates that there are both
external and internal factors that affect inflation in small, open developing
economies. Policies to reduce the rate of increase in lending rates can reduce the
rate of inflation somewhat. Structural features of the Bangladesh economy
determine the extent to which increases in import prices affect the inflation rate.
In such a situation, an examination of the structure of imports is needed. If the
imports that are rapidly increasing in price can be identified, either a long-term
policy of import replacement or substitution could be adopted or alternative
markets could be sought. However, in a world of rapid inflation, the latter
alternative would be difficult. An alternative to be considered is revaluation,
which would reduce import prices in terms of the domestic currency while export
prices in terms of the foreign currency would remain constant. A revaluation can
only be regarded as a short-term measure.
In terms of further research possibilities, it is clear that we can deepen our
understanding of the inflationary process through more detailed micro studies.
These studies would examine the factors which determine increases in individual
commodities. As stated earlier, the effects of inflation have been ignored in this
study. In small, developing economies these effects are crucial, and they are
deserving of a separate study. The revenue-raising possibility of inflation,
through the “inflation tax,” is also an unexplored area. Work on inflation is still
embryonic. We hope that this study will set the stage for more quantitative
research on inflation in small, developing economies.
10 D.U. Journal of Marketing, Vol. 16, No. 1, June 2013

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