Central Banking Report

The Growth-Inflation relationship in Bangladesh 2014

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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.

Central Banking Report

Education