Central Banking Report

The Growth-Inflation relationship in Bangladesh 2014
1
Abstract:
Inflation has appeared to be a major strain on the economy of the country in the recent past.
Understanding the relationship between inflation and output growth is very crucial in setting the
targets of policy goals, inflation in particular and formulating the policy framework. Several
cross-country and single country studies on the issue indicate that the relationship between
inflation and output growth is not linear and there exist a threshold level of inflation, up to which
inflation appears to be helpful for economic growth and beyond which it appears to impede
growth. This simply means that likewise the cost of high inflation, keeping too low inflation is
also costly in terms of output loss. The objective of this study is to explore the inflation, causes
and its historical trends. In this regard, the current study makes an attempt to examine the
relationship between inflation and output growth to identify a realistic level of threshold level of
inflation in Bangladesh. It is widely believed that moderate and stable inflation rates promote the
development process of a country, and hence economic growth. Moderate inflation supplements
return to savers, enhances investment, and therefore, accelerates economic growth of the country.
This paper empirically explores the present relationship between inflation and economic growth
in the context of Bangladesh. Using annual data set on real GDP and CPI for the period of 1980
to 2014, specifically, our conclusion is of direct relevance to the conduct of the monetary policy
by the Bangladesh Bank.

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Chapter - 1
Introduction

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1.1 Introduction:
Inflation-targeting central banks frequently justify their narrow focus on inflation by arguing that
maintaining a low and stable rate of inflation is the best way for them to promote high
employment and output. Yet, neither mainstream economic theory nor existing empirical studies
offer much support for the belief that a country's real economic performance is significantly
improved by reducing the trend rate of inflation, except in extreme circumstances. Indeed,
reducing inflation too close to zero worsens economic performance because of downward
nominal wage rigidity. Moreover, too low a rate of inflation can result in real instability because
of the zero lower bound on nominal interest rates. Given the lack of support from economic
science, and because of the dangers posed by nominal wage rigidity and the zero lower bound,
inflation-targeting central banks are reluctant to reduce their targets below 2 or 3 percent.
However, the commonly acknowledged weakness of the micro foundations of mainstream
monetary theory leaves many wondering if there might still be significant costs of inflation that
theorists have not yet discovered.
1.2 Objective of the Case Study:
Primary objective:
The main objective of the study is to know how the factors of Central Banking and Monetary
Policy work in our country.
Secondary objective:
The case study has the following objectives:

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 To know about Inflation, unemployment, Growth Trend.
 How inflation and Growth Trend fluctuate.
 Relationship among the inflation, and growth trend.
 Causes behind the inflation, unemployment and growth trend.
1.3 Scope:
There were huge scopes to work in the area of this Case Study. Considering the dead line, and
exposure of the paper has been wide-ranging. The study “The Growth-Inflation relationship in
Bangladesh” has covered overall scenario of Central Banking and Monetary Policy situation of
Bangladesh. It has measured the living standard of mass people. We have a chance to work on
the economic variable used in modern economic world. By doing the assignment, we are able to
know that the importance of inflation, unemployment & growth trend to assess how the people of
the country living in. In the case study we have showed how the above variables are inter related
on each other.
1.4 Methodology:
We have used the concept of the course, information of the case study.
Sources of Data:
Here the secondary sources of information were used. The secondary sources are: Books and
Website.

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Limitations:
While conducting the report on “The Growth-Inflation relationship in Bangladesh”, some
limitations were yet present there:
 Because of time shortage many related area can’t be focused in depth.
 Website in different organization of Bangladesh contains poor information.
 Recent data and information on different activities was unavailable.

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Chapter-2
Growth-Inflation Relationship – Inflation Causes & Data Analysis

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2.1 Definition:
“Too much money in circulation causes the money to lose value”-this is the true meaning of
inflation. The popular opinion about the costs of inflation is that inflation makes everyone worse
off by reducing the purchasing power of incomes, eroding living standards and adding, in many
ways, to life’s uncertainties. In economics, inflation is a rise in the general level of prices of
goods and services in an economy over a period of time. Inflation refers to a rise in prices that
causes the purchasing power of a nation to fall. Inflation is a normal economic development as
long as the annual percentage remains low; once the percentage rises over a pre-determined
level, it is considered an inflation crisis. In another word “Inflation means that your money won’t
buy as much today as you could yesterday”.
2.2 Effect of Inflation in Economy:
General Effect:
An increase in the general level of prices implies a decrease in the purchasing power of the
currency. That is, when the general level of prices rises, each monetary unit buys fewer goods
and services. Increases in the price level (inflation) erode the real value of money (the functional
currency) and other items with an underlying monetary nature (e.g. loans and bonds). For
example if one takes a loan where the stated interest rate is 6% and the inflation rate is at 3%, the
real interest rate that one are paying for the loan is 3%. It would also hold true that if one had a
loan at a fixed interest rate of 6% and the inflation rate jumped to 20% one would have a real
interest rate of -14%.

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Negative Effect:
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add
inefficiencies in the market, and make it difficult for companies to budget or plan long-term.
Inflation can act as a drag on productivity as companies are forced to shift resources away from
products and services in order to focus on profit and losses from currency inflation. Uncertainty
about the future purchasing power of money discourages investment and saving and inflation can
impose hidden tax increases. In case of international trade, ‘Higher inflation in one economy
than another will cause the first economy's exports to become more expensive and affect the
balance of trade’
Positive Effect:
Positive effects include ensuring central banks can adjust nominal interest rates (intended to
mitigate recessions), and encouraging investment in non-monetary capital projects. It puts impact
on Labor-market adjustments, Room to maneuver, Mundell-Tobin effect, Instability with
Deflation etc.
2.3 Causes behind inflation:
In developing countries, in contrast, inflation is not a purely monetary phenomenon, but is often
linked with fiscal imbalances and deficiencies in sound internal economic policies. Beside,
factors typically related to fiscal imbalances such as higher money growth and exchange rate
depreciation arising from a balance of payments crisis dominate the inflation process in

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developing countries. There were different schools of thought as to the causes of inflation. Most
can be divided into two broad areas:
1. Quality theories of inflation
2. Quantity theories of inflation.
The quality theory of inflation rests on the expectation of a seller accepting currency to be able to
exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory
of inflation rests on the quantity equation of money that relates the money supply, its velocity,
and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory
of inflation for money, and a quality theory of inflation for production.
After analyzing two theories of causes we have got here some physical cause to face which cover
both theories depending on a number of factors. These are given below-
Excess of money:
Inflation can happen when governments print an excess of money to deal with a crisis. As a
result, prices end up rising at an extremely high speed to keep up with the currency surplus. This
is called the demand-pull, in which prices are forced upwards because of a high demand.
Rise in production cost:
Another common cause of inflation is a rise in production costs, which leads to an increase in the
price of the final product. For example, if raw materials increase in price, this leads to the cost of
production increasing, which in turn leads to the company increasing prices to maintain steady
profits? Rising labor costs can also lead to inflation. As workers demand wage increases,
companies usually chose to pass on those costs to their customers.

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International lending & national debt:
Inflation can also be caused by international lending and national debts. As nations borrow
money, they have to deal with interests, which in the end cause prices to rise as a way of keeping
up with their debts. A deep drop of the exchange rate can also result in inflation, as governments
will have to deal with differences in the import/export level.
Government taxes:
Finally, inflation can be caused by federal taxes put on consumer products such as cigarettes or
fuel. As the taxes rise, suppliers often pass on the burden to the consumer; the catch, however, is
that once prices have increased, they rarely go back, even if the taxes are later reduced.
War:
Wars are often cause for inflation, as governments must both recoup the money spent and repay
the funds borrowed from the central bank. War often affects everything from international
trading to labor costs to product demand, so in the end it always produces a rise in prices.
2.4: Growth-Inflation Rate from 1971-2013:
Table 1:
Year GDP Growth Rate Inflation Rate
1971 -5.47 2.96
1972 -13.97 4.40
1973 3.32 61.40
1974 9.59 44.54
1975 -4.08 80.56
1976 5.66 -17.63
1977 2.67 -3.21

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1978 7.07 25.61
1979 4.80 12.56
1980 0.81 17.55
1981 3.80 10.52
1982 2.37 9.68
1983 4.01 8.51
1984 5.18 14.04
1985 3.22 11.14
1986 4.24 8.00
1987 3.73 10.88
1988 2.15 7.60
1989 2.61 8.50
1990 5.94 6.33
1991 3.33 6.59
1992 5.03 2.97
1993 4.57 0.28
1994 4.08 3.77
1995 4.92 7.34
1996 4.62 4.23
1997 5.38 3.09
1998 5.22 5.27
1999 4.86 4.65
2000 5.94 1.85
2001 5.27 1.58
2002 4.41 3.19
2003 5.25 4.52
2004 6.27 4.24
2005 5.95 5.07
2006 6.62 5.17
2007 6.42 6.78
2008 6.19 8.78
2009 5.74 6.52
2010 6.06 6.47

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2011 6.70 7.53
2012 6.23 8.48
2013 6.03 6.62
2014 - -
Source: World Bank
2.5: Data Analysis:
In view of visualizing the relationship between inflation and GDP growth in Bangladesh, several
Statistical tables and charts containing CPI inflation, real GDP during the period from 1971 to
2013 are used. The last row of Table-1 depicts the average inflation and growth of Real GDP for
four decades. After the liberation war in Bangladesh it was quite understandable that the rate of
inflation was higher and GDP growth was lower. From FY1971 to FY1981 the average inflation
rate was 21.75 percent that was reason of the lower GDP growth rate at 1.29 percent. It is seen
from the Table-1 that during the decade of FY82 to FY91, the inflation rate was around 9.12
percent, while the GDP growth was 3.67 percent. During the decade of FY92 to FY01, the CPI
inflation rate decreased significantly from around 10 percent to 3.50 percent, and the GDP
growth increased moderately to 4.98 percent from 3.93 percent. During the decade of FY02 to
FY13, however, the real GDP growth increased to around 6 percent, the CPI inflation also
increased to around 6 percent as well. From the table, it is evident that when money supply was
the highest (i.e., 22 percent), the inflation rate was much higher with lower real GDP growth
(i.e., around 4 percent). During the current decade, the state of inflation, real GDP growth deem
to be optimal as the average CPI inflation and real GDP growth both appeared to be around 6
percent.

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Chart 1: Growth-Inflation Rate Relationship
Chart-1 shows the relationship between the CPI inflation and real GDP growth for the period
1977-78 to 2009-10. It is evident from the chart that during the late 80s to late 90s, when the
rates of inflation were higher, the corresponding average GDP growth was relatively lower.
During 1990s and 2000s, however, inflation and growth maintained some sort of neutral
relationship. Although from FY04 onward matching with the period of flexible exchange rate
regime, the real GDP growth was relatively higher corresponding to relatively lower rates of
inflation. It can also be noted from the chart that the relationship between inflation and growth is
not linear that might go through some structural breaks requiring further investigation.
Table 2: Average Growth-Inflation in last four decades.
Fiscal Year Average Inflation Rate Average Growth rate
FY 1971-1981 21.75 1.29
FY 1982-1991 9.12 3.67
FY 1992-2001 3.50 4.98
FY 2002-2013 6.14 6.02
Table-2 contains the data on inflation and real GDP growth in Bangladesh for the last 42 years
(1975-76 to 2011-12) in a way that various levels of GDP growth are recorded against a low-to-
high sequence of inflation levels. The recorded data show that when the rates of inflation are
around 20 percent the corresponding average GDP growth is around 1.50 percent in FY70s. It is

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also seen from the table that when inflation rates are between 3 to 3.99 percent, the real GDP
growth is 5 percent. While inflation rates are in between 7 to 7.99 percent, the corresponding
average real GDP growth rate is one of the highest at 5.94 percent for 4 different years. Beyond
the 7.99 percent inflation, the average real GDP growth started to moderate. Thus the above
variety relationship between inflation and GDP growth indicates some sort of non-linearity with
a structural break or inflexion point when the relationship between inflation and GDP growth
switched.
2.6 Limitations of Economic system
The quarterly data on budget deficit and government expenditures are not available, which
hinders the analysis on the supply side determinants of inflation. The wage rate is not considered
here because of the developing country nature, Labor is assumed to be abundant. The key
findings:
Inflation in Bangladesh can be explained by money supply growth as money supply has
statistically significant power of forecasting the movement in CPI. It might be channeled through
either the effects of money supply on GDP or the effects of money supply on exchange rates.

The deposit rate of interest is a relatively weak determinant of fluctuations in inflation in
Bangladesh, whereas deposit rate of interest is a moderately strong determinant of nominal
exchange rate, but only in the short run.


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Money supply is a moderate determinant of fluctuation in real output, at the same time; money
supply is a moderately strong determinant of fluctuation in nominal exchange rate in Bangladesh
during the period FY90-FY10.

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Chapter – 3
Conclusion

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3. Conclusion:
These results have important policy implications for both domestic policy makers and the
development partners.
First, taking into consideration that the inflation rate is not indexed in the wages and salaries,
inflation will lead to a decrease in the purchasing power and an increase in the cost of living.
Second, given that the country frequently has to balance the credit requirements by the private
and public sector against both inflationary and balance of payments pressures, it is not always
possible for the monetary authority to increase (or adjust) the nominal interest rate above the
expected (or actual) inflation rate through contractionary monetary policy 11. In this regard, the
monetary authority can think of an alternative way by working on the expectations channel to
reduce inflation. This requires credibility of the monetary authority in following through its
monetary program as communicated in advance to the stakeholders.

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References:
 Chief economist’s unit and monetary department, Bangladesh bank “ Monetary Policy
Statement”, July – December 2014.
 World Bank Website.
 IMF Website.
 Sadia Afrin, “ Fiscal Deficit and Inflation: The case of Bangladesh”, July1, 2013.
 The Innovators, Centre for research and action on development, “Bangladesh Economic
Update – Growth, Tax, Inflation and Consumers”, July 2010.
 The Innovators, Centre for research and action on development, “Bangladesh Economic
Update – Inflation Unemployment and Growth Trajectory”, October 2010.
 Shamim Ahmed and Md. Golam Mortaza, “Inflation and Economic Growth of
Bangladesh: 1981-2005”, December 2005.
 Dr. Sayera Younus, “Estimating Growth-Inflation tradeoff threshold in Bangladesh”.
 Quamrul Asraf, Peter Howitt and, Boris Greshman, “How Ination A_ects
Macroeconomic Performance: An Agent-Based Computational Investigation” June -
2013.
 The Financial Express, “Inflation and food security in Bangladesh: Recent trends”,
Anniversary Issue 2011.
 Bangladesh Bureau of Statistics.

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