Bangladesh Bank (BB) will soon announce the Monetary Policy Statement (MPS) for the fiscal year (FY) 2014-2015. Monetary policy rests on the relationship between the rates of interest in an economy, that is, the price at which money can be borrowed, and the total supply of money. A policy is referred to as contractionary if it reduces the size of the money supply or increases it only slowly, or if it raises the interest rate. An expansionary policy increases the size of the money supply more rapidly, or decreases the interest rate. Often, monetary policies are also described as accommodative, if the interest rate set by the monetary authority is intended to boost economic growth; neutral, if it is intended neither to boost growth nor combat inflation; or tight if intended to reduce inflation.
Monetary policy in developing market economies faces different sets of challenges compared with developed market economies. Economic models that attempt to identify a reaction function for the monetary authority focus on central bank activities in developed countries. Those in developing countries, in contrast, do not get the same attention, owing to the now outdated belief that central banks were created with the primary objective of financing the government deficit. There has been, however, a growing surge of interest in analyzing monetary policy in developing countries. Differentiation has been drawn between two types of policies: accommodative and stabilizing. An accommodative policy provides a steady supply of credit for an expanding economy. In contrast, a stabilizing policy is used to dampen, or offset, undesired changes affecting the economy. In the accommodative scenario, monetary growth accommodates output growth and price inflation. In the stabilizing scenario, the monetary authority varies monetary growth in order to counter the effects of other shocks, depending on the objectives of monetary policy.
The short-run growth-inflation tradeoff is alive and well in developing countries. Regardless of the intentions, the ultimate result of fluctuations in the money supply will be absorbed in output growth and price inflation. The transmission mechanism of monetary policy to the real economy is through aggregate demand. The size of the aggregate demand shift is dependent on the liquidity effect attributed to a change in the money supply and the sensitivity of the aggregate demand to the change in liquidity. Notwithstanding excess liquidity, crowding out could still arise, however, if inflationary expectations develop and/or capital outflow increases. Assuming that monetary policy is effective in stimulating demand growth, the allocation of the change in demand between output growth and price inflation is dependent on constraints on the supply side of the economy. Capacity constraints are bound to accelerate price inflation. This is particularly likely when wages and prices are flexible upwards, as in Bangladesh.
The tightness of the tradeoff depends on structural constraints. What is the evidence on the impact of accommodative versus stabilizing monetary policy on growth and inflation in developing countries? A recent paper "On the effects of monetary policy shocks in developing countries" (Magda Kandil, an IMF staff, 2014) analyzes data from 122 developing countries covering the period 1968-2008. The author in this paper uses cross-country regressions to evaluate constraints that determine the allocation of monetary shocks between output growth and price inflation across countries: supply constraints, the responsiveness of aggregate demand to monetary policy changes, and the variability of monetary shocks themselves. Underlying these factors are structural constraints on the demand and supply sides of the economy.
Monetary policy can influence output in developing countries. Both demand and supply constraints differentiate the impact of monetary policy on real growth across countries. The response of real growth increases the more responsive aggregate demand to the change in monetary growth. Supply-side constraints decrease the output response in the face of monetary shocks. Across countries, trend output growth increases the higher the response of real growth to monetary shocks, implying an important role for monetary policy to revive growth by availing liquidity for capacity building. The results indicate that monetary policy plays a vital role in determining trend real output growth and the impact is asymmetric. That is, capacity building appears to be robust to cyclical dry-up in liquidity during monetary contraction.
Monetary policy can affect both the trend and variability of inflation. Structural constraints are key determinants of the effectiveness of monetary policy. When supply is capacity and structurally constrained, monetary expansion is largely inflationary. In addition, the variability of monetary shocks increases both the trend and variability of price inflation across countries. Higher monetary variability increases uncertainty and increases the speed of price adjustment, escalating trend price inflation. Also, higher monetary variability increases inflationary expectation, which contributes to higher trend inflation across countries. Capacity constraints appear to be particularly binding, limiting output adjustment in the face of expansionary monetary policy.
Stabilizing inflationary expectations has to be the central objective. To maximize the effect of monetary policy as an instrument of economic development, a number of structural constraints need to be addressed through complementary policies such as financial and business regulation. On the demand side, monetary policy should aim at maximizing the positive effect of credit availability on private spending by addressing structural bottlenecks (such as credit market imperfections) that block the transmission mechanism and interfere with demand response. Furthermore, policy credibility is important to curb inflationary expectations that could trigger a cycle of capital outflows and reduce inflows. The success of monetary policy in controlling inflationary expectation is also necessary to stabilize the exchange rate, safeguard competitiveness, and anchor inflationary expectations toward achieving macroeconomic stability. On the supply side, failures to stimulate output growth in the face of monetary fluctuations signal the presence of binding capacity constraints that hinder output adjustment. In light of these constraints, the objectives of monetary policy should be geared explicitly toward stabilizing inflationary expectations and increasing incentives for growth-inductive private activity.
So, what do these findings imply about the stance BB should adopt in the forthcoming MPS?
Bangladesh Bank has maintained a reasonable balance between accommodation and stabilization in recent years. BB succeeded in reducing core (non-food) inflation (from its recent peak of 11.3 per cent in October 2012 to 5.4 per cent in June 2014) and maintaining a stable nominal exchange rate. Unlike in many developing countries, BB is allowed operational autonomy. Hence, the objectives of monetary policy can be clearly defined. In the MPS for January-June 2014 this was stated as follows: "The monetary stance in H2 FY14…….will target a monetary growth path which aims to bring average inflation down to 7.0%, while ensuring that credit growth is sufficient to stimulate inclusive economic growth." Despite the fact that both reserve money and broad money growth has been below the MPS target, the 7.3 per cent inflation in FY14 has exceeded both the MPS target as well as that of last year's 6.8 per cent.
There is no compelling reason to shift the monetary stance. The stabilizing policy this year need not differ from that of last year. However, the FY15 budget has laid a much more challenging 6.0 per cent inflation and 7.3 per cent growth target. If BB attempts to get even remotely close to the growth target, it will need to increase liquidity in order to increase credit expansion, making achievement of the inflation target more difficult. In addition, this could become complicated if BB is obliged to provide credit to finance increased government spending envisaged in the FY15 budget in the event revenue mobilization and external financing are short of target, as is likely. It could then crowd out private spending.
Under present circumstances of excess liquidity in the banking system, crowding-out is unlikely. But it cannot be ruled out if recovery in private investment leads to stronger demand for credit in the private sector later in the year. Additionally, the increased government spending may not be appropriately geared towards expanding productive capacity. Hence, higher government spending may prove inflationary. Financing the increased government spending via monetization is also likely to deplete the stock of foreign reserves in a small open economy such as Bangladesh. As a result, allowing depreciation of taka may prove necessary, increasing the risk of a vicious cycle of depreciation and inflation. Surely, BB will refrain from loosening monetary policy to cover the shortage in fiscal policy or to compensate for policy failings in the stock market or public banks.
BB should continue a stance focusing on stability of the inflation and exchange rates. Capacity utilization in Bangladesh's manufacturing is already very high. According to IFC's Enterprise Survey 2013, capacity utilization is on average 84 per cent, compared with 73 per cent average for the 122 countries covered by the survey. It is well known that capacity expansion is severely limited, among other factors, by availability of serviced land, onerous regulation, political uncertainty, and skills. Under low excess capacity and structural constraints on capacity expansion, monetary accommodation is likely to fuel inflation with little, if any, favourable impact on growth. BB should therefore err on the side of stable inflation and exchange rate.
BB should ensure adequate space for private sector credit growth in the monetary program. Setting a private-sector credit growth target at around 16 to 17 per cent should provide enough room for accommodating any resurgence in demand for credit in the private sector. With easing of structural constraints on capacity expansion, BB should accommodate increased demand for liquidity to finance productive capacity expansion. This means BB may set priorities in reaction to developments in the economy. The implementation of monetary policy may emphasize the stability of the price level, the exchange rate, or output growth, depending on the state of the economy. However, exercise of discretion should remain bounded by the monetary program targets or else it may put policy predictability and credibility at risk.
[The writers are respectively Lead Economist and Country Director (Bangladesh, Bhutan and Nepal), the World Bank. Email: mmahbub@worldbank.org]
How should the forthcoming Monetary Policy Statement look?
Zahid Hussain and Johannes Zutt | Published: July 22, 2014 00:00:00 | Updated: November 30, 2026 06:01:00
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