Developing a macro model for monetary programming

Financial inclusion has emerged as a tool to achieve inclusive growth for poverty reduction in recent years, and policymakers in Bangladesh have adopted financial inclusion as one of the key strategies for alleviation of poverty. Financial inclusion is defined narrowly as the access to financial services. In Bangladesh, financial inclusion is referred to as access to financial services from officially regulated and supervised entities. This definition should be widened to include the access to insurance services regulated by Insurance Development and Regulatory Authority. Innovation of micro-insurance services in the late 1980s in Bangladesh and subsequent modification from time to time to make micro-insurance products available to low-income households at affordable cost is seen as expanding financial inclusion.
United Nation defines financial inclusion as the access to the range of financial services at a reasonable cost for the bankable people and farms. Thus connected with the words 'financial inclusion' is the notion of access to financial services to low-income households at affordable cost. While financial inclusion can give the low-income households the opportunities of the access to financial services and enables them to augment their income, the banks, the key financial intermediaries, should not be over-exposed. Supply-led credit at low cost could, in the long run, end up with high default rates. As size of loan and deposit amount tends to be smaller cost of administering such services would be high. Unless a well-researched supervisory system is put in place the overenthusiastic financial inclusion could lead to higher provisioning requirement and also higher operating cost. Regarding financial inclusion Mr. Raghuram Rajan, Governor, Reserve Bank of India in his public lecture in Dhaka said "we have to be careful about over-promising and we should not also be over-pessimistic."
The basic framework of monetary policy in Bangladesh is to estimate safe limit of monetary expansion on the basis of expected growth of real GDP (gross domestic product), tolerable rate of inflation and change in income velocity of money which depends to a large extent on the rate of monetisation of the economy. In the available literature on monetary programming exercise made by the monetary authorities in Bangladesh it is indicated that income velocity of money in most of the years was assumed constant.   After the safe limit of monetary expansion is determined, the level of net foreign assets of the banking is projected to estimate permissible expansion in domestic assets during a given period.   Control of money supply depends, among other things, on the monetary authorities' ability to make realistic projection of the change in net foreign assets of the banking system and its ability to control net domestic assets of the banking system, which includes also loans borrowed by the Government from the banking system.
While ceiling of credit to the Government is based on borrowing requirement of the Government as envisaged in Government's annual fiscal budget, credit ceiling for the other public sector is also  based on the  its borrowing requirement. Maximum allowable credit limit for the private sector would be derived as residual within the framework of overall expansion in net domestic assets of the banking system. The overall and sectoral credit programmes are made on an annual basis, but quarterly phasing of the credit programmes is made by taking into consideration the influence of seasonal factors. After the overall credit ceiling is drawn, credit ceiling for each bank is made on the basis of its share in outstanding credit at the end of the preceding quarter.
Fixation of credit ceiling for each bank on the basis of each bank's share in total outstanding credit means that each bank's performance in respect of loan recovery would remain the same and that the capacity of credit creation out of their own resources would also remain unchanged.  Banks whose outstanding loans contain a large amount of overdue loans are treated equally with the banks whose outstanding loans contain little or no overdue loans. This policy apparently contradicts the central bank's efforts of reducing the share of overdue loans in total outstanding bank credit.
However, in the late 1980s and on the eve of financial sector reform bank-by-bank credit ceiling was discontinued. Following the financial sector reform the central bank adopted indirect measures to bring about desired changes in monetary aggregates. This practice, which is still in force, has been made operational, firstly, through introduction of Bangladesh Bank Bill and later by use of Repos and reverse Repos.
Reserve money which is commonly referred to in the literature as a monetary base or high powered money represents monetary liabilities of the central bank including its currency liabilities and the currency liabilities of the government. In Bangladesh, reserve money comprises total currency held by the public, cash with scheduled banks and deposits of all banks with Bangladesh Bank. These liabilities are matched by the assets of the central bank. The sources of change in monetary base are changes in (i) net foreign assets held by Bangladesh Bank, (ii) claims on government (net) by Bangladesh Bank, (iii) credit to scheduled banks by Bangladesh Bank, and (iv) other assets (net) of Bangladesh Bank. The ability of Bangladesh Bank to control monetary base, therefore, depends on its ability of control these four sources. Credit to scheduled banks by Bangladesh Bank and other assets (net) of Bangladesh Bank are amenable to control by Bangladesh Bank. To the extent that there is a proper coordination between fiscal and monetary policy, control of Bangladesh Bank`s credit to the Government is not difficult but in practice such control is not always possible since the central bank's credit to the Government depends largely on the Government's borrowing requirement and as a result, actual outcome sometimes diverges widely from the projected level. There have been large differences between the actual and projected level of net foreign assets in some of the years. However, errors in projection of some of the components of monetary base offset the errors in other components making the overall monetary base not very far from the projected level.  
Money supply, as mentioned earlier, not only depends on the monetary base but also on the money multiplier. Even if the central bank can control the monetary base, its ability to control money supply depends on its ability to predict the value of the money multiplier. While  setting reserve requirements of commercial banks is within the purview of the central bank, other elements of the money multiplier such as excess reserves of the banks and the currency ratio depend on the behaviour of the banks and the public respectively, and therefore their control does not lie within the powers of the central bank. The central bank can, however, influence the behaviour of the commercial banks and the public through appropriate policy measures. However, it is not an easy task to make precise estimate of the effects of these policy measures on the behaviour of commercial banks and the public.
Monetary programming of the central bank is basically based on the relationship between money, price and output, which is summarised in one equation in the form of demand for real money balances. It is implicitly assumed that the demand for real money balances is stable and that the causation runs from real income to money. This means that real income remains uninfluenced by change in money. Since domestic credit of the banking system is one of the causative factors of the change in money, the process of money creation is simultaneously the process of credit creation. While increase in domestic credit facilitates creation of output, inflationary pressure emanating from monetary expansion caused by increase in domestic credit is neutralised by the increase in output. The central bank could therefore consider developing a macro model focusing on the relationship between output, price and money, update the estimates of the parameters of the model periodically and apply the model for monetary programming exercise.
M Shefaque Ahmed, Actuary is
Chairman of Insurance Development and Regulatory Authority (IDRA). The views expressed in this article
are the author's own.
mshefaqueahmed@gmail.com