Professor Rafiqul Islam
Department of Business Administration
Faculty of Business & Entrepreneurship
Daffodil International University (DIU)
Money, Monetary Policy and Central Bank Functions: Bangladesh Perspectives
Any discussion on monetary policy requires some understanding of the importance of money, financial markets and financial institutions. Money, credit or the whole structure of financial institutions can contribute greatly to improvement of standard of living in society but it does so only indirectly by helping man to become much more productive. Money in the modern economy is viewed as lubricant that greases the wheel of economic activity. Without money, the transactions that make up our daily economic routine would be extremely difficult and so is saving and investment. Money also plays a key role in influencing the behavior of the economy as a whole and performance of the financial institutions and markets.
More specifically changes in the supply of money and credit can affect how rapidly the economy grows, the level of employment and the rate of inflation and these in turn can affect the value of financial assets held by individuals and financial institutions.As a matter of fact to appreciate the importance of money in an economic system, it is instructive to speculate on what the economy might be without money.For one thing without money individuals in the economy would have to devote more time to buying what they want and selling what they do not want, the introduction of money has simplified matters.
Workers are now paid in money which they can use to pay for their goods and services. Money is the medium of exchange. Besides this, money serves as a medium of measuring the value and also facilitates deferred payments.The importance of money becomes more obvious in its relevance to financial institutions and markets. Money contributes to economic development and growth by stipulating both saving and investment and facilitating transfer of funds from savers to borrowers who want to undertake investment projects, who do not have their own money to do so. Financial markets give savers a variety of ways to lend to borrowers, thereby increasing the volume of both savings and investment and encouraging economic growth.
People who save are not often the same people who can see and exploit profitable investment opportunities. The introduction of money, however permits the separation of the act of investment from the act of saving. Money makes it possible for a person to invest without first refraining from consumption (saving) and likewise makes it possible for a person to save without also investing. People who are not fortunate enough to have their own savings now can invest. Monetary policies of the central bank are transmitted through the financial institutions. Hence, financial institutions have sprung up- such as commercial banks, saving banks, saving banks & loan associations, credit unions, insurance companies, etc.
Meaning of Monetary Policy
Monetary policy refers to the tools used by government through the Central Bank to conduct the supply of money. Dr. Paul Einzing defined monetary policy as the attitude of the political authority towards the monetary system of the community under its control. It comprises all measures applied by monetary authorities to produce a deliberate impact on the nature and volume of money in circulation. According to Harry Jonson, Monetary policy is the policy employing the central banks control of the supply of money as an instrument for achieving the objectives of general economic policy.
The Conduct of Monetary Policy
No central bank can avoid involvement with the conduct of monetary policy. This is because the conduct of monetary policy must involve the setting of short term interest rates and this is done by central bank by using its own role in the money markets, exploiting its position as banker to the rest of the banking system. ln fact six basic goals are mentioned with regard to the objectives of monetary policy: (1) high employment, (2) economic growth, (3) price stability, (4) interest rate stability, (5) stability of financial markets, (6) stability of foreign exchange market [Stanley and Eakins, 2000] Monetary policies are formulated and implemented in order to achieve certain objectives or goals which are stated below.
The Goals of Monetary Policy
High employment is an important goal for two reasons: (1) the alternative situation of high unemployment causes human misery, with families suffering From financial distress, loss of personal self-respect and increase incrime and (2) when unemployment is high, the economy has not only idle workers, but also idle resources like closed factories, unused equipment which results
in loss of output. However, the goal for high employment should not seek an unemployment level of zero but rather a level above zero consistent with full employment at which the demand for labor equals the supply of labor.This level is called the natural level of unemployment.
The goalof steady economic growth is related to high employment- growth because businesses are more likely to invest in capital equipment to increase productive activity and economic growth when unemployment is low. Conversely, if unemployment is high and factories are idle, it does not pay for firms to invest in additional plants and equipment. Although the two goals are specificallyrelated, policies can be specifically aimed at promoting economic growth by directly encouraging firms to invest or by encouraging people to save, which provides more funds for firms to invest.In fact this is the stated purpose of so-called supply-side economic policies, which are intended to spur economic growth by providing tax incentives for businesses to invest in factories and equipment and for tax payers to save more.
Stable price level is considered as a goal of monetary policy. Price stability is desirable because a rising price level creates uncertainty in an economy and may hamper economic growth. For example,the information provided by prices of goods and services is harderto interpretwhen the overall level of prices is changing which complicates decision making for consumers, businesses and government. A growing body of evidence suggests that inflation leads to lower economic growth. Inflation also makes it hard for the future to plan. For example it is more difficult to decide how much fund should be put aside to provide for a child'scollege education in an inflationary environment. Further, inflation may strain a country’s social fabric.
Interest Rate Stability
Interest rate stability may be desirable because fluctuations in interest rates can create uncertainty and make it harder to plan for the future. Fluctuations in interest rates that affect consumers' willingness to buy houses, for example, make it more difficult for customers to decide when to purchase a house and construction firms to plan how many houses to build. Upward movements in interest rates may also create hostility by the affected groups in society.
Stability in Financial Markets
Financial crises can interfere with the ability of financial markets to channel funds to people with productive investment opportunities, thereby leading to a sharp contraction in economic activity. The promotion of a more stable financial system in which financial crises are avoided is thus an important goalfor a central bank.
The stability of financial markets is also fostered by interest rate stability, because fluctuations in interest rates create great uncertainty for financial institutions. An increase in interest rates produces large capital tosses on long term bonds and mortgages, losses that can cause the failure of the financial institutions holding them.
Stability in the Foreign Exchange market
Withincreasing importance of international trade, exchange rate policy has become a major consideration of monetary policy. A rise in the value of currency will make that country’s exports more expensive to foreign countries, and a fall in the value of currency will make imports more expensive.In addition, preventing large changes in the value of a currency makes it easier for firms and individuals purchasing selling goods abroad to plan ahead. Stabilizing extreme movements in the value of a currency in the foreign exchange market is thus viewed as a worthy goal of monetary policy.
Maintenance of balance of payments equilibrium
Balance of payments of a country sometime may be deficit and sometime surplus. A persistent deficit in the balance of payments of a country may be a cause of concern forthatcountry.A surplus, under certain circumstances, may also cause problems. Maintenance of an appropriate balance of payments,through properconductof monetarypolicy,becomes an added responsibilityof a central bank.
The Conflict among Goals
Although many of the goals mentioned are consistent with each other, high employment and economic growth, interest rate stability and financial market stability, this is not always the case. These objectives are not necessarily compatible. The goal ofprice stability often conflicts with the goals of interest rate stability and high employment in the short run (but probably not in the long run). For example, when the economy is expanding and unemployment is falling, both interest rates and inflation starts to rise. If the central bank tries to prevent a rise in interest rates to prevent inflation, this may cause the economy to overheat and stimulate inflation. But if a central bank prevent inflation, in the short run unemployment may rise. The conflict among goals may thus present central banks with some hard choices.
The Application of Monetary Policy: Rules versus Discretion
The debate about whether monetary policy decisions should be governed by rules or discretion has a long history. However, neither pure discretion nor fixed adherence to an intermediate monetary target has proved satisfactory. In their place several countries are moving toward a regime in which there is a clear target for the ultimate objective of monetary policy, together with a statement of the authorities'decisionmaking practices that is as open and transparent as possible.
We notice three broad phases in the approach to policy making in the postwar period. Until about the late 1960s, it was taken for granted, that formulating monetary policy required a substantial amount of discretion. From the early 1970s untilthe 1980s, there was a growing emphasis on rules. By the late 1980s; however,there was a swing away from rule based policy regimes. The relationship between intermediate targets and ultimate objectives became more variable under the influence of financial liberalization and innovation. In recent years, it seems most central banks have recognized the need for a return to greater discretion in the use of monetary instruments.
ln this context, it is necessary toprovide the definition of a fewterms,because the same expressions may be used to mean different things by different authors. Central banks use policy instruments to pursue ultimate policy objectives. Along the way, they are concerned with intermediate variables, which are part of the policy transmission process, as well as with indicator variables which may provide information about the impact of policy, without themselves being part of the transmission mechanism
Rules are generally taken to require the authorities to use the instruments of monetary policy to achieve a given predetermined path for an intermediate variable (usually a monetary aggregate). Intermediate variables are those which the monetary authorities may attempt to target because of their presumed relationshipwith the ultimate objectives of monetary policy.The most common example of an intermediate variable is the money stock or credit stock. To the extent that growth in monetary aggregates is stably related to the ultimate objective of monetary policy (the steady growth of the nominal value of output) and to the extent that it is more feasible to control the money stock than nominal output, it makes sense to direct policy instruments towards the achievement of an intermediate variable.
Indicator variables can be defined as those that have information value about the impact of instrument on policy outcomes, but are not themselves an object of control. In fact the whole range” of economic quantities has a bearing on monetary policy decisions. They can include variables that in another context may be viewed as intermediate target. For example the growth of money stock can be regarded as object to be controlled. It can also be regarded as one indicator (among others) of the potential strength of demand in the economy. This underlines an important point: just because a monetary variable is not used as an object of control does not mean that it does not play an important role in evaluating the stance of monetary policy.
Other indicator variables are those that convey information about the future of the economy, and the balance between inflationary and recessionary forces. They include all variables relating to the current and prospective level of real economic activity [GDP growth, industrial production, Retail sales, consumer and business spending surveys, etc. They also include cost and price indicators [wages, import costs, consumer and producer price indices] and expectation indices, including expectations derived from financialvariables such as the shape of the yield curve.
The distinction between whether variables are to be treated as indicators or intermediate targets is crucial to the distinction between rules and discretion. However, the distinction between rules and discretion is not straightforward, and, hence deserves some clarification. The use of discretion in monetary policy is clearly not intended to imply randomness in decision making. A discretionary policy action usually reflects a systematic response by policy authorities, taken in the light of their objectives, and their perceptions as to how the economy will respond to particular economic stimuli.
Arguments for discretion in the formulation and implementation of policy:
First economics is subject to both supply shocks and demand shocks. The appropriate monetary policy response will be quite different in the two cases. If the authorities can identify the nature of different shocks, they will be able to improve welfare by exercising discretion in how they respond to them.
A second argument for discretion lies in the fact that the speed with which an economy returns to price stability following an inflationary or deflationary shock has implications for output and employment. The use of discretion may enable the central bank to tolerate some overshooting of the monetary targets, to allow the return to price stability to take place in a more orderly manner.
A third argument for discretion is that the structure of the economy is changing through time in ways that cannot easily be predicted in advance. The relationship between intermediate variables and the ultimate objectives of policy can be affected by technical developments. Under such circumstances discretion, rather than a set rules, could be more appropriate.
Arguments for rules
One is the Libertarian principle that, in a democracy, discretion from decision making should be removed from individuals and vested in rules and laws. Perhaps the more important economic argument for rule is that there is fundamentally stable relationship between an intermediate variable ( a monetary aggreg4te ) and the ultimate objective of monetary policy (the growth of nominal income ).The benefits of discretion are, therefore small, since it is not possible to improve much on the outcome generated by adopting a stable money growth target. On the other hand, so the argument goes, the costs of discretion are potentially large
A subsidiary argument for rules is that financial markets operate most efficiently in the presence of certainty. If in addition to the inherent uncertainties generated by outside economic shocks, there are uncertainties about the authority’s policyresponse, the difficulties faced by markets will be compounded. This argument has been formalized in the literature on the time consistencyproblem and the value of rules that "pre-commit" the authorities to a particular course of action ( Kydland and Prescott,1977).
The arguments in favor of rules are based more on the quality of discretionary action, than on discretion per se. It may be argued that discretionary monetary policy is subject to two systematic sources of adverse bias: "too little, too late ". For example, there will be greater willingness to lower interest rates than to raise them (Kohn, 1993)
Functions of Bangladesh Bank: The Central Bank of Bangladesh
Bangladesh Bank Carries out the following main functions as the country’s Central Bank:
Formulating monetary and credit policies.
Managing currency issue and regulatory payment system.
Managing foreign exchange reserves and regulating the foreign exchange market.
Regulating and supervising banks and financial institutions.
Advising the government on interactions and impact of fiscal, monetary and other economic functions.
Achieving balance of payments equilibrium.
Towards performing the above functions, the commitment of BB to diverse stakeholders are as follows:
1. For the Nation:The BB shall catalyze and support socially responsible and environmentally sustainable development initiatives including financial inclusion of underserved productive sectors and bringing in needed new dimensions in financial markets and institutions to facilitate broad based growth in output, employment and income for rapid poverty eradication and inclusive economic and social progress.
2. For the Government: The BB adopt and implement monetary and credit policies conforming withnational priorities in coordination with fiscal and other macroeconomic objectives. The BB shall also optimize foreign exchange revenues and returns thereon, maintain stability in financial markets curbing excessive volatility and provide analysis and advice to the government on issues in economic management and development.
3. For Depositors in Banks and Financial Institutions, Investors and in Financial Assets: The BB shall ensure safety of deposits in licensed banks and financial institutions with onsite and offsite supervision of their authorities and with adequate financial information disclosure requirements, besides insuring small deposits. The BB should maintain an interest rate structure that provides fair returns on financial assets while also supporting growth in the real sector and should also promote and support development of markets in bonds and securities.
4. For Banks and Financial Institutions in Bangladesh:The BB shall provide prudential regulatory risk management and disclosure framework to protect solvency and liquidity of the overall financial system, acting as lender of last resort in and when needed.
Strategic Action Plan of BB 2010-2014
Strategies are means to achieving goals. Ten strategies have been identified by Bangladesh Bank to address the possible development and change. All BB departments/branch offices will drill down the strategies into performance management system (PMS). The strategies are mentioned below without any in-depth study about the outcome of these strategies. These is scope for research about the strategic plan.
• Strategy: 01Revisit the current monetary policy framework to ensure continuing effectiveness of monetary policies.
• Strategy: 02 Strengthen regulatory and supervisory framework to enhance financial sector resilience and stability.
• Strategy: 03 further deepen financial markets in Bangladesh.
• Strategy: 04 financial inclusion and borrowing of access.
• Strategy: 05 Develop more efficient currency management and payment system.
• Strategy: 06 Strengthen revenue management capabilities.
• Strategy: 07 Enhance regulatory and supervisory framework against money laundering.
• Strategy: 08 Introduce separate comprehensive guidance and supervision for Islamic Banking.
• Strategy: 09 Develop more efficient management of government domestic debt.
• Strategy: 10 Full automation of Credit Information Bureau (CIB)
Critical success factors (CSF) are the most vital elements or activities in strategic planning process that are important for strategies to be successful. Some CSF are mentioned below:
Rules of law, good governance, social and political stability.
Quick, efficient process of commercial dispute settlement.
Sustained level of confidence of the stakeholders on financial system.
Central Bank autonomy and operational independence.
Efficient involvement and ownership of management and strategic planning.
Efficient Communication, coordination and logistic support.
Focus on weak areas in values, culture and behavior.
Adequate efforts and opportunities for expertise development.
Efficient knowledge management.
Failure to attract best people in the market and retention.
Understanding of staff’s capabilities and proper development.
Implementation of business continuity plans including process reengineering.
To be continued………………