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Inflationary Effect of Remittance and Exchange Rate
Bangladesh Perspective

2011 .Inflationary Effect of Remittance and Exchange Rate Bangladesh Perspective Prepared for Dr. Mohammed Farashuddin Course Instructor: Macro-economics Course Code: E202 Prepared by Moshfeqa Karim RQ 08 BBA 17th Batch Institute of Business Administration University of Dhaka Date of Submission: 2 June.

There are two side of factors of inflation  Demand side  Supply side In this paper two interrelated factors representing the two sides in the context of Bangladesh will be examined. which is second only to the nine billion dollars earned by ready-made garment exports. inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Inflation erodes the purchasing power from general people.INTRODUCTION INFLATION In economics. DEMAND SIDE FACTOR-REMITTANCE A remittance is a transfer of money by a foreign worker to his or her home country. SUPPLY SIDE FACTOR-EXCHANGE RATE An exchange rate (also known as the foreign-exchange rate. It has been argued that remittances have inflationary effect as it induces a rising demand but supply . But the toughest macroeconomic management dilemma of balancing the positive effects with the unapparent and lagged negative flow-on effects also exists in case of remittance. forex rate or FX rate) between two currencies is the rate at which one currency will be exchanged for another. REMITTANCE AND INFLATION Remittances have worked as a catalyst in poverty alleviation and economic growth in Bangladesh. Nearly six million people work abroad and send home over eight billion dollars every year.

An increase in the household income due to remittances results in a decrease in the labor supply. which drives up the price . An increase in remittances could cause a real exchange rate appreciation via rising domestic prices. If this is not absorbed into productive sectors (or capital investment). The extent of the effect of a rising level of remittances on domestic prices depends on the exchange rate regime of the country.does not respond accordingly. This creates short-run excess demand. then it goes into consumption expenditure. which stimulates consumption expenditure. MECHANISM The effect of remittances on inflation can be viewed from three different perspectives:  Appreciating exchange rates  Increasing money supply  Balance of payments The rising level of remittances can have a spending effect. some studies differ to agree to this. Inflation may rise to such an extent that the positive effects of remittances may get annihilated. Remittances also boost real wealth. This can trigger a rise in the price level of non-tradable. On the other hand. A shrinking labor supply is associated with higher wages and higher production costs. When large inflows of foreign exchange are remitted by expatriates to their home country. The increase in domestic prices due to a high exchange rate which results from high remittances can also be explained from the viewpoint of exchange rate pass-through. fuelling inflation. the conversion of this foreign exchange into domestic currency raises the money supply. This can potentially result in an increase in inflation.

As a result. When such a requirement is in force. This will result in further appreciation of the exchange rate. BANGLADESH PERSPECTIVE EFFECT ON MONEY SUPPLY Central bank of Bangladesh Bangladesh Bank. Failure of Bangladesh bank to fully sterilize the increase in international reserves will lead to an increase in the monetary base. The relationship between remittances and inflation can also be looked at from the point of view of the balance of payments and foreign reserves accumulation. any remittance shows up in the balance sheet of Bangladesh Bank as an increase in . requires commercial banks to surrender most of their foreign exchange receipts to it in exchange of local money. as follows. there will be an upward pressure on prices.level. Remittances can also be a source of balance-of-payments surplus and international reserves accumulation.

EFFECT ON EXCHANGE RATE The other effect of remittances is on the foreign exchange rate for Bangladesh this is usually the Taka-US Dollar rate. This may be explained with the help of two basic monetary equations. This means that a 100 Dollar inward remittance will raise reserves by about 7000 Taka (100 dollar ×70Taka/Dollar).33). appreciates. One of these is sterilization for example sale of credit (government bonds or bills) to the public or what is called in Bangladesh Bank parlance. For Bangladesh Bank Total High-Powered Money (or Reserve Money) = Domestic Credit (or Assets) +International Reserves The money that we use in our daily transactions derives from the quantity of high-powered reserves and international reserve has immediate implications for the supply of domestic money. or what is the same thing. the supply of foreign exchange increases. taka. Total supply of money=Money Multiplier × High-powered money The value of the money multiplier in Bangladesh during recent months has been about 4. The central bank has instruments to prevent money supply from increasing. 'Reverse Repo' operations. But there is a limit to sterilization activism of Bangladesh Bank without risking money and credit crunch and a possible recession. This allows the Bangladesh Bank to mop up excess liquidity from the market. which will finally translate into an increase in money supply of 0100 Taka (7000 Taka ×4. . the local currency. A large increase in remittances thus translates into a correspondingly large increase in money supply or liquidity.33. and the value of the foreign currency tends to depreciate. When there is a large inflow of foreign exchange.

it also increased the reserves held by Bangladesh Bank. .100 Crore Taka. In the recent past Bangladesh Bank aggressively intervened in the foreign exchange market to mop up excess foreign currency from the market. say. it increased reserve money by 7. The figure shows different levels of Remittance. The economy may probably reach the last limit where it becomes impossible to absorb more government bonds or bills at the existing terms and conditions.Bangladesh Bank intervenes in the market to stop this from happening by purchasing whatever foreign currency stock the commercial banks hold. This increased the international reserves which in turn increased the money supply of the economy by the money multiplier as given by the equation above. but there is a limit to its use.000 Crore Taka. International reserve is presented in billion US Dollar and inflation in percentage. international reserve and Inflation Rates of Bangladesh Remittance from and 2004-11. 1 Billion Dollar. If Bangladesh Bank mopped up. On the other hand devaluation of Taka causes import cost to increase which results in higher price level and inflation. and therefore added to the money supply by 30. This could have caused mayhem to our export sector and thereby the entire economy. the value of the Dollar. Otherwise the value of the US dollar could have fallen to a very low level. While this shored up the demand for the foreign currency (US Dollar). and hence. The Bangladesh Bank could in theory sterilize this by engaging in Reverse Repo.

The current lull is the right time to prepare for the contingent outcomes. . the Bangladesh government should devise policies to motivate Remittance Receiving Households to channel a significant amount of remittances for productive investments rather than for consumption. A large increase in demand will most likely stoke the fire of inflation. In that vein.65 X the change in monetary base (4. Commercial banks are unable to lend the excess liquidity since investment demand has dried up and import costs have fallen.9 percent to 14.RECOMMENDATIONS Fortunately for the country the rising liquidity has not shown up in rising inflation mainly because of the current recession. like Ecuador and other Latin American countries. If 100% of the forex remittances are monetized in domestic currency while no active sterilization by Bangladesh Bank's reverse repos operations are in effect and the recipients squander the entire remittances in consumption. This has significantly dampened aggregate demand of the economy. If remittances maintain their bullish tendency the major problem will be managing aggregate demand. When the world economy emerges out of the current recessionary spell.6 percent. changes in the weekly or monthly money supply will = 4. Since high inflation and Relative Price Variability involve welfare costs. the domestic economy is expected to pick up momentum. which put a lid on the prices but as well as on growth.67 is the average of seven quarter M2 money multiplier). The growth rate of private credit has fallen precipitously from 24. an accelerated inflation will be unavoidable.

0 per cent from June 2003 to April 2004. Bangladesh had been maintaining various pegged exchange rate regimes  Pegged to the British pound sterling (1972-1979)  Pegged to a basket of currencies of major trading partners with Pound Sterling as the intervening currency (1980-1982)  Pegged to a basket of currencies of major trading partners with US Dollar as the intervening currency (1983-1999)  Adjustable pegged system (2000-2003). Exchange rate kept on rising gradually from mid-2004 and it reached its peak at Tk. 2003 Bangladesh switched to floating exchange rate system by abandoning the adjustable pegged system. MECHANISM Among supply-side factors. it remains fairly stable and has been fluctuating between Taka 68 and 69 (2007-2009) except in this year it reached 73. On May 31. The floating regime in Bangladesh is. The transition to a floating regime was smooth and the first ten months can be viewed as a "honeymoon period" for Bangladesh as the exchange rate remained fairly stable experiencing a depreciation of less than 1. A depreciation of exchange rate translates into a rise in the cost of imported . exchange rate is found to be significant in explaining inflation in Bangladesh.EXCHANGE RATE AND INFLATION Exchange rate management is one of the central issues of macroeconomic policies. Since then. 70/USD in 2006 from Tk. 58/USD. HISTORY Historically. characterized by both volatility and stability. accounting for 20 per cent depreciation. therefore.

dollar in the face of major economic shocks. By buying the foreign exchange.commodities by making foreign goods more expensive. any depreciation of the exchange rate has been associated with a pickup in inflation by increasing the prices of imported goods. Liquidity expansion. The unusual level of stability against the U. points to the fact that Bangladesh Bank is following a policy of a virtual peg against the U. The depreciation of Taka makes imported commodities more expensive having bearing on the domestic price level. dollar. the interventions that Bangladesh Bank made in the foreign exchange market to keep the value of the taka stable or unchanged essentially amounted to the purchases of huge quantities of foreign exchange by the Bangladesh Bank. Bangladesh Bank injected equivalent amount of taka into the economy contributing to a massive increase in the money supply. An appreciated currency would have helped reduce domestic inflation rate by making imports cheaper. which could not happen due to the de facto peg. including the global economic crisis. The expansion in broad money was well beyond the target of 15. thereby fueling the inflationary pressure. But the exchange rate has been virtually unchanged at about Tk. Exchange rate depreciates inflationary rate There is another important factor-exchange rate regime.5 per cent envisaged in the Monetary Policy Statement of Bangladesh Bank announced in June increases the prices of imported commodities increases the . There is a close association between exchange rate fluctuations and inflation. and thus induces an increase in the domestic price level.S. The Bangladesh Bank has de facto lost control on money supply or liquidity expansion in the economy. Second.S. as measured by broad money (M2) grew by more than 22 per cent in Financial Year 2010. Officially Bangladesh maintains floating exchange rate system. The policy of de facto fixed exchange rate regime contributes to higher inflation in two ways. BANGLADESH PERSPECTIVE Since the adoption of a floating exchange rate regime in May 2003. 68/69 per US dollar for the last several years.

Central banks can target the nominal exchange rate and successfully defend that under certain circumstances. While achieving exchange rate stability. If we observe the differential between the interbank exchange rate and the curb market exchange rate. Injection of dollar liquidity into the curb market will be the best course of action. has now widened by five to six-fold. its control over inflation. Such intervention will be financially beneficial for Bangladesh Bank's balance sheet because it will be selling dollars for a much higher amount of taka in the curb market. the real exchange rate of a currency is determined by the . while in the interbank market the rate is less than 69 Taka per Dollar. but they cannot do anything about the real exchange rate in the medium and long run. It needs to choose between its exchange rate or inflation objectives. the Bangladesh Bank has not succeeded in preventing the appreciation of the real value of taka. Bangladesh Bank lost control on its money supply. It shows that despite the apparent stability in the nominal exchange rate against the U. Currently 1 US dollar is selling for 74 to 75 Taka in the curb market. It will not be possible to achieve both with one single instrument called monetary policy. RECOMMENDATIONS Measures must be taken to narrow the spread between interbank and the curb market.2009. while buying it in the interbank market at a much lower cost (in taka terms). Many of the gains achieved in recent years to attract inflow of workers remittances into the formal interbank market may be eroded if this spread remains as large as it is now. This widening trend is not desirable and will inevitably lead to many distortions in the economy. which used to be less than 1 Taka per Dollar.S. we notice that the spread. Because in the end. People will be tempted to make transactions through the curb market instead of going through the formal interbank channel. or if it widens further. dollar. Another uncomfortable development is also happening in the exchange market in recent months. This is the real dilemma that the Bangladesh Bank is facing today. The visible stability in the interbank market exchange rate is nowhere to be found in the curb market. and in the process.

net/newDesign/ of the economy.pdf http://www.php . CONCLUSION The above explained two factors have contradictory effects to inflation. It cannot target both The Policy makers need to find the optimum tradeoff between the two to keep inflation at a low level. At present Bangladesh is in such position where efficient policies can create scopes and era of shared development but wrong policies or inactivity may lead to serious setbacks. and the strengthening of the value of the taka in real terms is a reflection of the underlying improvements in the fundamentals of Bangladesh economy.thedailystar. REFERENCES http://bdeconomywatch. Bangladesh Bank needs to be clear about its objective: it has to choose between inflation and exchange rate objectives. Effort to manage one factor results in distortions in the other.php?nid=113652 http://www.