1.
Monetary policy
Mohammad Maksudul Huq Chowdhury
Head of Branch
Export Import Bank of Bangladesh Limited, Islampur Branch

2.
What is a Policy

3.
What is Money
Money is anything that is generally acceptable to
sellers in exchange for goods and services.
A liquid asset is an asset that can easily (i.e., quickly,
cheaply, conveniently) be exchanged for goods and
services.

4.
Characteristics of Money
1. Medium of Exchange – Token that can be offered
as a payment for goods.
2. Unit of Account – All goods will have a value in
money and, thus, can be used to measure all
goods
3. Store of Value – If money is to be accepted for
goods today it must have durable value. (Money
is an Asset).

5.
Two categories of money
1. Definitive Money (sometimes known as monetary
base/narrow money): Money that can be used
immediately for transactions without conversion to
more basic forms of money.
- Currency+ Reserve accounts
2. Broad Money: A set of assets, typically some form
of bank deposit, which can be easily converted to
definitive money.
- Checking Accounts, Savings Accounts, Liquid
Time Deposits and CD’s

6.
Broad Money vs. Narrow Money
1. Broad money has grown much faster than narrow
money.
2. Narrow money is money directly controlled by the
government.
3. Broad money includes money printed by the
government plus deposits at banks.
4. Money multiplier is ratio of broad money to narrow
money.

7.
What is Monetary Policy
It is the government’s decision about how much
money to supply to the economy. This means
controlling the supply of Broad Money vs. Narrow
Money.

8.
History of Monetary Policy
 In old times, monetary policy was mainly focused
to maintain the value of money.
 Inflation was not a big concern
 Bank of England created in 1694
 During 1870 – 1920 industrialized nations set up
central banks
 Monetary policy came into question during the
great depression.

9.
Monetary Policy Can be-
1. Loose or
2. Tight

10.
Loose monetary policy
 If the Central Bank implements a loose monetary
policy (often called expansionary), the supply of
credit increases and its cost falls.
 A loose monetary policy is often implemented as
an attempt to encourage economic growth.

11.
Tight monetary policy
 If the Central Bank allows a tight monetary policy
(often called contractionary), the supply of credit
decreases and its cost increases.
 Any nation wants a tight money policy - In order
to control inflation.

12.
The Two Faces of Monetary Policy

13.
Goals of Monetary Policy
 Price stability
 GDP growth
 Investment
 Fight recession
 Exchange rate stabilization
 Desired level of unemployment rate

14.
How these goals are achieved by controlling
money supply?
 Price Stability: for example, price is shooting up
and we want to control it…
We
reduce
money
supply
Now
people
have
less
money
at hand
So,
people
buy less
amount
of
goods
Demand
for
goods
falls
Producers
reduce
price to
maintain
sales

15.
 Investment can be induced by controlling money
supply
 GDP growth: for example, we want to increase
GDP growth…
We
increase
money
supply
Now
people
have
more
money
at hand
So,
people
buy
more
amount
of
goods
Demand
for
goods
rise
Producers
produce
more
goods to
match
market
demand

16.
 For example: our export is reducing and we want
to increase it…
We
increase
money
supply
As a
result
banks
have
more
idle
money
So,
banks
reduce
interest
rate
Cost of
investment
falls and
goods
become
cheaper
Export
rises

17.
Channels through which monetary policy works
 Interest Rate channel
 Exchange rate channel
 Credit channel

18.
How is the money supply controlled
 The Central Bank generally uses three tools
 Open market operation (OMO)
 Discount rate (DR)
 Reserve ratio (RR)

19.
Open Market Operation (OMO)
 Defined as the buying or selling of treasury bills
and bonds by the Bangladesh Bank in the
open market.
 Expansionary – Bangladesh Bank buys bonds
(injects money)
 Contractionary – Bangladesh Bank sells bonds
(pulls out money)

20.
Characteristics of OMO
 Sometimes done for temporary periods
 Repurchase Agreement -- BB buys bond
with agreement to sell it back.
 Matched-Sale Purchase -- BB sells bond
with agreement to buy it back.
 Occurs at the initiative of the BB.
 BB is in complete control.
 They are flexible: BB can do small or large
amounts.
 They are reversible: BB can undo policy mistakes.
 Very low-key policy instrument: difficult to tell
what BB has done

21.
Discount Rate
 Defined as the rate of interest charged to banks
that borrow from the BB.
 Expansionary -- BB lowers discount rate.
 Contractionary -- BB raises discount rate.

22.
Characteristics of DR
 Done at the discretion of the commercial banks
 Affects interest rate structure of the commercial
and specialized banks
 DR may influence economic activity

23.
Reserve Ratio (RR)
 Banks are required to maintain a certain
percentage of their deposits in the form of
reserves or balances with the BB. This percentage
is called the Reserve Ratio.
 Expansionary Policy -- BB lowers reserve
ratios.
 Contractionary Policy -- BB raises reserve
ratios.

24.
Characteristics of RR
 Too blunt -- needs tiny changes for reasonable
adjustments in money growth.
 Too Disruptive -- affects all banks balance sheets.

25.
Strategies of Monetary Policy
 Money Growth Targeting
 Inflation Targeting

26.
Money Growth Targeting
 The decade of 1970s was characterized by high
inflation and unemployment
 Central banks initially pursued money growth
targeting to achieve steady growth and low
inflation
 In this strategy central banks announces the rate
of growth of money for the next one year
 But in 1980s, in spite of low inflation, output and
unemployment were unstable in USA, UK,
Canada and Germany

27.
 Because, due to changing financial system,
money demand was hard to predict and,
therefore, money growth targeting was
ineffective
 A tightly regulated financial system is necessary
for money growth targeting to be successful. Tight
financial regulation is often not possible
 Specially, in the developing countries, where
financial reforms are still taking place, strict
financial regulations are not viable

28.
Inflation Targeting
 Central banks in many countries adopted
inflation targeting during 1990s. New Zealand was
the pioneer.
 In this strategy central bank announces the
rate(s) of inflation that it wants to achieve over
the next year(s)
 Through this announcement the central bank
signals that hitting that target in the long-run is its
number one priority

29.
 Inflation targeting bypasses the problem of
money demand instability
 Also, it helps to make central bank’s
commitments credible to the people as most of
the people understands what goal the central
bank is trying to achieve
 However, success of inflation targeting depends
on how quickly the economy responds to the
policy changes
 If the economy responds to policy changes
slowly then inflation targeting may lose credibility

30.
The Issue of Credibility
 Monetary policy has important goals for the
country
 If these goals are not achieved, then operation of
the monetary policy tools are not effective
 People do not have faith in monetary policy
anymore
 Monetary policy lose credibility
 Country’s development objectives fall into chaos

31.
How can the central bank maintain credibility:
 Appointing a “tough central banker”
 In 1979, in the face of serious inflation US
President Jimmy Carter appointed Paul
Volcker, who succeeded to curb
inflation… but failed to check
unemployment!!!
 Changing central bankers’ incentives
 For example, if the head of the central
bank is easy to remove s/he might want
to be serious about her/his commitments

32.
 Increasing central bank’s independence
 If the central bank is independent it might be free
of political influence, and hence,
might escape political pressure to increase
output and employment (say, before national
election)

33.
Monetary Policy and Inflation
 “Inflation is always and everywhere a monetary
phenomenon.” – Milton Friedman
 Historical evidence suggests a strong link
between high growth rates in the money supply
and high inflation
 Does correlation imply causality here?
 Could some other variable be driving
both inflation and money growth in the
same direction?

34.
 Why would money growth and inflation be
related?
 Inflation is the result of too many money
chasing too few goods
 When the amount of money (currency)
increases, but the number of goods does
not, then prices must rise.

35.
Hyperinflation
 A period of abnormally high growth in the cost of
living is a hyperinflation
 Behind every hyperinflation is an extremely
high rate of growth in money.

36.
 The German Hyperinflation, 1921-1923
 Costs of rebuilding and reparations payments
induced the Weimar government to print
more money.
 As the pace of money supply growth
increased, so too did inflation.
 At one point prices were rising by 41% per
day
 Inflation became a self-fulfilling prophecy as
people rushed to make purchases as soon as
they received any money.
 Inflation only ended when confidence was
restored in the value of the currency.

37.
Inflation and Money: Theory
 Empirical evidence suggests a causal
relationship between money growth and inflation
 A theoretical link may be established using the
AD-AS model
 The basic intuition is that increasing the
money supply will give people more
spending power, but does not actually
increase productive capacity
 As a result, prices must eventually rise to
account for increased demand without any
increase in supply

38.
 Increasing the money supply shifts the AD curve
right. This expands output in the short run, but
only prices in the long run.
 A sustained increase in the rate of money supply
growth will lead to a sustained increase in the
rate of inflation.

39.
Inflation is Purely a Monetary Phenomenon
 Recall that we define inflation as the percentage
change in the cost of living from one year to the
next
 A one time increase in the money supply will
cause prices to rise (positive inflation)
 An increase in the growth rate of the money
supply will cause the rate at which prices rise
(inflation) to increase

40.
 Suppose government spending increases by 20%
next year
 Prices will rise next year, but the increase in
the level of government spending is only
enough to increase prices once.
 A permanent increase in the growth rate of
government spending could increase
inflation, but there is an upper limit on how
much the government can spend (no more
than 100% of GDP)
 Similarly, temporary supply shocks can
cause prices to change, but cannot cause
changes in the rate of inflation.

41.
Why do we see inflationary monetary policy
 If we agree that high inflation is bad and that
high inflation can only be caused by
expansionary monetary policy, why would the
central bank ever choose to expand the growth
rate of money?
 Demand-Pull Inflation
 The central bank is committed to an
unemployment target below the natural rate,
leading to a continual expansion of the
money supply to push output above full
employment.

42.
 Cost-Push Inflation
 Worker demands (or expectations of
inflation) for higher salaries raise costs,
leading to more unemployment. The central
bank expands the money supply to restore
full employment.
 Government Budget Deficits
 The government finances its budget deficit
by printing more money or getting the
central bank to buy government bonds
which it then retires.

43.
Budget Deficits and Inflation
 There are three ways a government can pay for
its purchases
 With money from tax revenue
 With money borrowed from the public in the
form of bonds
 With money borrowed from the central bank
(i.e. money printed up for the government).

44.
 If the government finances a deficit through tax
increases or borrowing directly from the public,
there is no change in the money supply.
 If the government borrows from the central bank,
it will cause the money supply to increase.
 A sustained budget deficit could lead to inflation.
 Budget deficits are notable causes of inflation in
countries with shallow credit markets.

45.
Monetary Policy in Bangladesh
 Until 1990:
 limited role of BB
 Government directly controlled exchange
rate and interest rate
 Taka was pegged against foreign currencies
 Financial Sector Reform Program started in 1989
 Strategy was to target monetary aggregates
 Free floating exchange rate was introduced in
May, 2003
 Bangladesh Bank is regularly issuing Monetary
Policy Statement since January 2006

46.
Limitations of Monetary Policy
 Does not work when aggregate demand needs
to be stimulated through direct government
spending (Great Depression)
 Works on the economy through indirect
channels. Therefore, often suffers from lag to
have impact
 May be dominated by fiscal policy
 Wrong policy may result in severe damage for
the economy

47.
Monetary Policy vs. Fiscal Policy
 If the goals of the two policies do not match,
development objective will be damaged.
Example:
 Suppose, Bangladesh is suffering from high
inflation and BB wants to reduce it. BB reduces
money supply…
 But, national election is close and will be held
within a year.
 So, the ruling party decides to spend more
money on safety-net programs and employment
generating activities
 Accordingly, the ruling party sets its fiscal policy
so that expenditure goes up…
 What will happen?

48.
Other problems related to mismatch of policies
 If the government borrows too much from the
banking system, then little money is left for the
private sector to borrow.
 As a result, private sector initiatives are
hampered
 This is called the “crowding out effect”
 Because of crowding out private investment falls
and GDP falls as well
 In this case, if the monetary policy authority
wants to enhance private sector credit growth,
practically it has little room to do so…

49.
Government debt:
 If the government borrows a lot, it means that at
some point of time future, the government will
have to pay substantial amount of interest when
the loan matures
 If at that time, the government does not have
money enough to pay the interest, it might print
money for the purpose…
 This means that money supply will go up
 But, if the country at that time suffers from high
inflation and BB wants to control it, the
contractionary monetary policy will not help.

50.
Monetary Policy Framework of Bangladesh Bank
The monetary policy framework of Bangladesh Bank
identifies a logical and sequential set of actions for
designing and conducting the monetary policy. The
framework is based on credible information on the
stability of the money demand function, the money
supply process, and the monetary transmission
mechanism.
Monetary policy in Bangladesh is framed using
projected real GDP growth rate. The targeted rate of
inflation adopts Reserve Money (RM) and Broad
money (M2) as operating and intermediate targets
respectively.

51.
Monetary policy consists of a set of rules that aim at
regulating the supply of money in accordance with
predetermined goals. Monetary policy is important
because it can influence economic growth, inflation,
and the balance of payments (BOP). The central
bank conducts monetary policy by using instruments
that influence the supply of money and interest rates
in the economy.

52.
The main policy goals of monetary policy of
Bangladesh Bank are:
 To achieve sustainable economic growth
 To maintain price stability
 To attain sustainable BoP

53.
The Key Players of Money Supply Process
in Bangladesh
The key players in the money supply process as
follows:
1.The Central Bank- The government agency that
oversees the banking system and is responsible for
the conduct of monetary policy; in Bangladesh, it is
Bangladesh Bank.
2. Banks (depository money banks (DMBs)) - The
financial intermediaries that accept deposits from
individual and institutions and make loans:
commercial banks, savings and loan associations,
mutual savings banks and credit unions.
Depositors- individuals and institutions that hold
deposits in banks.

54.
Analytical Balance Sheet of the Central Bank
Assets Liabilities
Net Foreign Assets Reserve Money
Net Domestic Assets Currency
Net Domestic Credit Currency held in bank
Net Claims on Government Currency in Circulation
Claims on DMBs Deposits of DMBs
Claims on private sector Other deposits
Other items net

55.
Factors Determining the Money Supply in
Bangladesh
1. The monetary base or reserve money -
components of the RM include currency in
circulation, currency held in banks, deposits of
DMBs and other deposits which creates the
monetary base for money supply

56.
2. The Money Multiplier - The central bank influences
the money supply by controlling Monetary Base
(MB), reserves and required reserve ratio. It can
be done through controlling money multiplier,
denoted by mm, which tells us how much the
money supply changes for a given change in the
monetary base. The relationship between the
money supply, the money multiplier, and the
monetary base is described by the following
equation:
M = mm *MB
The money multiplier mm tells us what multiple of
the monetary base is transformed into the money
supply

57.
Factors affecting the money multiplier
Based on the complex money multiplier that we have
derived above, we know that it is affected by three
factors:
a) The currency-deposit ratio (C/D)
b) The excess reserves-deposit ratio (E/D)
c) The required reserves ratio (R/D)

58.
3. Bank Deposits and Credits
4. Credit to the Public and Private Sector
5. Cash Reserve Requirement (CRR), Statutory
Liquidity Requirement (SLR) and Bank Rate
6. Interest rate and Inflation
7. Government Borrowing
8. Projection of Broad Money (M2) and Income
Velocity of Money