Course Name: Central Banking and Monetary Policy

Course No. FIN: 421

Chapter note
Prepared by SM Nahidul Islam
Dept. of Finance & Banking
Islamic University, Kushtia.
Chapter Monetary policy
Questions at a glance:
1.
2.
3.
4.
5.
6.
7.
8.
9.

Describe the history of monetary policy

Describe the different types of monetary policy
Describe the major instruments used by Bangladesh Bank
Describe the Frameworks of Bangladeshs Monetary Policy
Define bank rate & State the effects and limitation of variation of the bank rate
Define open market operations & State the limitations of open market operation.
State the limitations of Variations of Cash Reserve Ratios
Describe the Monetary Policy of Bangladesh
What are the limitations of Monetary Policy in Developing Country like Bangladesh?

1. Describe the history of monetary policy

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer: With the creation of the Bank of England in 1694, which acquired the responsibility to print
notes and back them with gold, the idea of monetary policy as independent of executive action began to
be established. The goal of monetary policy was to maintain the value of the coinage, print notes which
would trade at par to specie, and prevent coins from leaving circulation. The establishment of central
banks by industrializing nations was associated then with the desire to maintain the nation's peg to the
gold standard, and to trade in a narrow band with other gold back currencies. To accomplish this end,
central banks as part of the gold standard began setting the interest rates that they charged, both their own
borrowers, and other banks that required liquidity. The maintenance of a gold standard required almost
monthly adjustments of interest rates.
During the 1870-1920 periods the industrialized nations set up central banking systems, with one of the
last being the Federal Reserve in 1913. By this point the understanding of the central bank as the "lender
of last resort" was understood. It was also increasingly understood that interest rates had an effect on the
entire economy.
The advancement of monetary policy as a pseudo scientific discipline has been quite rapid in the last
150 years, and it has increased especially rapidly in the last 50 years. Monetary policy has grown from
simply increasing the monetary supply enough to keep up with both population growth and economic
activity. It must now take into account such diverse factors as:

short term interest rates;

long term interest rates;

velocity of money through the economy;

exchange rates;

credit quality;

bonds and equities

government versus private sector spending/savings;

international capital flows of money on large scales;

Financial derivatives such as options, swaps, futures contracts, etc.

2. Describe the different types of monetary policy

Answer: Different types of monetary policy are given below:
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
1. Inflation targeting: Under this policy approach the target is to keep inflation, under a particular
definition such as Consumer Price Index, within a desired range. The inflation target is achieved
through periodic adjustments to the Central Bank interest rate target. The interest rate used is
generally the inter-bank rate at which banks lend to each other overnight for cash flow purposes.
The interest rate target is maintained for a specific duration using open market operations.
This monetary policy approach was pioneered in New Zealand. It is currently used in the
Euro zone, Australia, Canada, New Zealand, Norway, Poland, Sweden, South Africa, Turkey, and
the United Kingdom.
2. Price level targeting: Price level targeting is similar to inflation targeting
except that CPI growth in one year is offset in subsequent years such that
over time the price level on aggregate does not move. Something akin to
price level targeting was tried in the 1930s by Sweden, and seems to have
contributed to the relatively good performance of the Swedish economy
during the Great Depression.
3. Monetary aggregates: In the 1980s several countries used this approach
based on a constant growth in the money supply. This approach was refined to
include different classes of money and credit (M0, M1 etc). This approach is
also sometimes called monetarism. Whilst most monetary policy focuses on a
price signal of one form or another this approach is focused on monetary
quantities.
4. Fixed exchange rate: This policy is based on maintaining a fixed exchange rate
with a foreign currency. There are varying degrees of fixed exchange rates,
which can be ranked in relation to how rigid the fixed exchange rate is with
the anchor nation.
These policies often abdicate monetary policy to the foreign monetary
authority or government as monetary policy in the pegging nation must align
with monetary policy in the anchor nation to maintain the exchange rate. The
degree to which local monetary policy becomes dependent on the anchor
nation depends on factors such as capital mobility, openness, credit channels
and other economic factors.

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
5. Gold standard: The gold standard is a system in which the price of the
national currency as measured in units of gold bars and is kept constant by
the daily buying and selling of base currency to other countries and nationals.
The selling of gold is very important for economic growth and stability. Today
this type of monetary policy is not used anywhere in the world, although a
form of gold standard was used widely across the world prior to 1971.
6. Mixed policy: In practice a mixed policy approach is most like "inflation
targeting". However some consideration is also given to other goals such as
economic growth, unemployment and asset bubbles. This type of policy was
used by the Federal Reserve in 1998.

3. Describe the major instruments used by Bangladesh Bank

Answer: Major instruments of monetary control available with Bangladesh Bank are given below:
1. Bank rate: Until 1990, the use of this instrument as the lending rate of the central bank for
borrowings of the commercial banks to meet their temporary needs was virtually non-existent in
Bangladesh. The rate was changed in a few occasions only to align it with the re fixation of the
rates of deposits and advances. Moreover, the existence of refinance facilities at rates lower than
the bank rate substantially eroded its significance. However, since 1990, the instrument has been
put in use to change the cost of borrowings for banks and thereby to affect the market rate of
interest. The present bank rate in Bangladesh is 6.75%.
2. Open market operations (OMO): These involve the sale or purchase of securities by the central
bank to withdraw liquid funds from the banking system or inject the same into that system. OMO
allows flexibility in terms of both the amount and timing of intervention, which did not exist in
Bangladesh before 1990. Bangladesh Bank introduced a 91-day Bangladesh Bank Bill, a marketbased tool for monetary intervention, in December 1990. The bank bill was subsequently
withdrawn from the market. At present, OMO operations are conducted through participation of
banks in monthly or fortnightly/weekly auctions of TREASURY BILLs.
3. Rediscount policy: After the introduction of Financial Sector Reform Program (FSRP), the
refinance facility was replaced by rediscount facility at bank rate to eliminate discrimination in
access to central bank funds. Refinance facility is now available for agricultural credit provided by
BANGLADESH KRISHI BANK and for projects of Bangladesh Rural Development Board financed by
SONALI BANK. Banks are advised to extend credit considering banker-customer relationship.
4. Statutory reserve requirement: Cash reserve requirement (CRR) of the deposit money banks has
a significant potential to regulate money supply through affecting money multiplier, while
statutory liquidity requirement (SLR) is generally used to affect the lending capability of the bank.
Bangladesh Bank used these two instruments very infrequently before 1990 and very often after
1990.

4. Describe the Frameworks of Bangladeshs Monetary Policy

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
Answer: The framework of Bangladeshs monetary policy is given below:
1. The Policy Target(s): The appropriate monetary policy strategy in the Bangladesh context would
be to achieve the goal of price stability with the highest sustainable output growth. Any monetary
stimulus to promote growth must keep in perspective the broader goal of macroeconomic stability,
which is a prerequisite for future growth. Price stability would also include the stability of the
currency regime. While fiscal policy too is relevant in addressing these goals and thus there is a
need for policy coordination, monetary policy must play its due role.
While leading central banks in the industrial world have increasingly adopted the unitary goal of
fighting inflation, interestingly directive by enumerating
The promotion of price stability,
Ensuring full employment,
Supporting global economic and financial stability as the chief monetary policy goals.
2. Inflation Target: It is the general wisdom that monetary policy tools are of immediate influence
in controlling inflation. However contemporary evidence amply illustrates that monetary policy
cannot deal well with the inflationary impact of external shocks such as the recent international
price of oil and related energy products. Many central banks as a consequence focus on the core
inflation, which is typically constructed by subtracting the most volatile components from the
consumer price index (CPI). While there is no standard measure of core inflation in the
Bangladesh context at this time, the construction methodology is made complex by two facts.
First is that food items constitute nearly 60 percent of the CPI index.
Secondly, in the Bangladesh context, the volatility of the international energy prices appear not to
filter down to the CPI since the relevant domestic prices are subsidized by the state.
3. Growth target: GDP growth projections of the Medium Term Macroeconomic Framework
(MTMF) in the government's National Strategy for Accelerated Poverty Reduction (NSAPR),
modified appropriately in the light of unfolding actual developments, are used as output growth
targets for the purpose of monetary policies.

5. Define bank rate & State the effects and limitation of variation of the bank rate
Answer: Bank rate is the rate at which the Central Bank is prepared to rediscount the approved
bills or to lend on eligible paper. By changing this rate the Central Bank control the volume of credit. The
effects of variation of bank rate are given below:
a. Effects on price level: If bank rate increases, cost of credit will increase and the businessmen will
reduce their borrowings from commercial banks. This will reduce production and increase
unemployment in the economy. As a result, income and price level will go down and depression in
business and trade will be the outcome. If there is a decrease in the bank rate the opposite results of
above will be experienced in the economy.
b. Effects on foreign trades: An increase in bank rate wills increases other interest rates in the
country. So, investment will be profitable. It will ensure the insertion of foreign capital into the
economy and leakage of domestic capital will be stopped. Moreover, increased bank rate will
decrease the piece level because amount of credit will be reduced into country. This decreased price
level will again encourage expert and discourage import, which will make balance of payment
favorable. Opposite effects of above will be experienced if the central bank decreases the bank rate
in the economy.
Limitations: The Bank Rate Policy suffers from the following limitations:
Islamic University, Kushtia

a.
b.
c.
d.
e.
f.

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
The rate of interest in money market may not change according to the changes in the bank rate.
In rigid economic system, i.e., planned and regulated economies, the prices and costs may not
change as a result of changes in the rate of interest.
The bank rate cannot be the sole regulator of the economic system, and the volume of savings and
investments cannot be controlled through the rate of interest alone.
The effect of rise in the bank rate in controlling credit for industrial and commercial purpose is
limited.
The change in the methods of financing by the business firms reduces the importance of bank rate
policy.
The bank rate policy does not discriminate the activities into productive and unproductive
activities.

6. Define open market operations & State the limitations of open market operation.
Answer: Open market operations refer to the buying and selling of government and other approved
securities by the central bank in order to curb deflationary and inflationary pressure in the economy. The
limitations of open market operations are given below:
a. Selling- It reduces amount of cash of commercial banks but if commercial banks take loan form
central bank it would not be effective to reduce credit.
b. Buying- It increases the amount of cash in commercial banks. But it may not be able to expand
credit if commercial banks repay loan to the central bank with this increased cash.
c. Depreciation- During depreciation credit expansion through purchasing credit instruments is not
possible. Because in this period, businessmen will not want to borrow from commercial bank.

7. State the limitations of Variations of Cash Reserve Ratios

Answer: The method of variation of reserve ratio suffers from the following limitations:
a. The method of variation of reserve ratio suffers from the following limitations:
b. This method may not be successful and effective if the commercial banks have excess cash
reserves with them.
c. The success of this method depends upon the customer's willingness to borrow from the banks. If
they are not willing to borrow the credit cannot be expanded.
d. This method imposes an increased burden on the credit system.
e. Discriminatory in effect that bank has to keep a certain percentage of cash reserves with the
Central Bank.
f. This method lacks flexibility.
g. This method is inexact and creates uncertainty.

8. Describe the Monetary Policy of Bangladesh

Answer: In the first years after liberation, the primary target of monetary policy of Bangladesh was to
regulate not the quantity of money, but the direction of the flow of money and credit in support of the
government financial programmed.
Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
In 1975, Bangladesh entered into a standby-arrangement with IMF and the country's monetary policy got
a changed shape, which fixed an explicit target of safe limit of monetary expansion on annual basis. With
this change, Bangladesh Bank started setting short-term objectives of monetary policy in close
collaboration of the government and tried to achieve the target by using the direct instrument of control.
Bangladesh Bank took measures to monitor credit and monetary expansion keeping in view the price
situation and international reserves position. Efforts were made to achieve the targeted growth of domestic
credit and thereby, the money supply, through imposing ceilings on credit to the government, public, and
private sectors.
Bangladesh Bank announces its monetary policy statement (MPS) for the second half of the current fiscal
year. Explicitly or implicitly, the objectives that the MPS seeks to accomplish are:
* Maintaining inflation at moderate levels.
* Limiting depletion of foreign exchange reserves and establishing external sector equilibrium
* Supporting GDP growth of 6.5 - 7.0%.

9. What are the limitations of Monetary Policy in Developing Country like Bangladesh?
Answer: In developing country, monetary policy suffers from the following limitations
1. In under developing countries, capital markets are narrow and unorganized. Hence, the
credit control mechanisms like open market operation, bank rate, etc. cannot be effective.
2. A narrow bill market makes the discount rate ineffective.
3. The existence of non-bank financial intermediaries also makes the credit control measures of
the central bank ineffective.
4. In under developed countries, banking habits are also underdeveloped which hampers the
effectiveness of monetary policy seriously.
5. In backward countries, monetary expansion generally leads to increase imports, unfavorable
balance of payments and loss of gold reserve, etc.
6. The role of monetary policy is not compulsive but permissive. This seriously limits the
efficiency of monetary policy in backward countries.
7. In under developed society where liquidity trap is in existence monetary policy cannot work
efficiently.
8. Administrative honesty and firmness are not very rigorous in less developed countries which
reduce the efficiency of monetary policy a policy a lot.

Islamic University, Kushtia

SM Nahidul Islam
Dept. of Finance & Banking (2nd batch)
9. Lastly, the lag between the decision about a particular policy and its implementation also
hinders the monetary policy in its success.
Here we found that monetary policy suffers from various limitations in the developing country. So,
it should be supplemented by fiscal policy to make it effective. Despite this information, monetary
policy sets the tone of economic development in recent years.

Islamic University, Kushtia