Monetary Policy

•Monetary policy is an important device for the

central bank of a country to maneuver the
economy in the short run – to stimulate the
economy when it is in slump or stagnation and
cool it down when it is overheated.

•The potency of monetary policy – the extent to

which changes in money supply can impact the
real economy - is still one of the moot issues in
macroeconomics. This is more debatable in the
context of developing countries where the
conducive environment required for monetary
policy to be effective is primarily absent.
 How monetary policy works

Policy Instruments → intermediate targets → macroeconomic

goals
Policy instruments are the banking variables over which the central bank
has full control such as open market operation, repo and reverse repo,
altering Cash Reserve Ratio, etc. Choice of the policy instruments
depends on the state of the financial market and the economy.

These policy variables are set to influence some intermediate targets

such as inter-bank interest rate, money supply (M2) etc. The central
bank remains vigilant about that the relationship between policy
instruments and the intermediate target and hope that it will be stable so
that central bank can fairly predict the change in intermediate target by
changing the policy instruments.
 How monetary policy works

Policy Instruments → intermediate targets → macroeconomic

goals
Most of the developed countries such as USA use inter-bank interest
rate (i.e. federal fund rate) as the intermediate target while most of the
developing countries use monetary base as the intermediate target.
Targeting inter-bank interest rate requires a well- functioning and
competitive banking sector, which the developing countries tend to lack.

We discuss these issues of instruments, targets and broad

macroeconomic goals in reverse order primarily in the context of
Bangladesh. Bangladesh Bank announces Monetary Policy Statement
(MPS) in every six months.
 How is money measured?

The money supply in the economy is measured through the

Monetary Survey - an aggregate balance sheet of all banks
in the economy that issues currency in the country. In the
case of Bangladesh, it will be the balance sheet of the
Bangladesh Bank. The methodology followed in the survey is
that recommended by the IMF.
 Narrow Money
Narrow Money (M1): The first item of monetary aggregates is
Narrow Money, also called M1, which consists of:

i. Currency in circulation (C) – Notes and Coins; also known as

Currency Outside banks; this is also called as M0.

ii. Demand Deposits (DD) in the banking system. Deposits are

also money as they are short term deposits that can be
converted into currency relatively easily and quickly. They can
also be used to repay debts. Demand Deposits include current
account, savings account and traveler’s check among other
short-term deposits.

Thus, we have: M1 = C + DD
 Broad Money
Broad Money (M2): First define a type of money termed as Quasi Money
(QM) and which includes time and savings deposit (TD) in the banks and
any foreign currency deposit (FC) of residents.

Now Broad Money (M2) which includes all liabilities in the banking
system and is defined as:

Broad Money (M2) = Narrow Money (NM) + Quasi Money (QM)

Thus, M2 includes everything in M1 and additionally includes savings

deposits (e.g. Post Office savings deposits), time deposits (e.g. fixed
deposits of different terms) and foreign currency deposits.
 Broad Money
Having studied the monetary aggregates, let us now see the definition used by the
Bangladesh Bank (BB). Table 1 provides the actual components reported by the
Bangladesh Bank in their money supply statistics.
 Broad Money

Therefore, Bangladesh Bank uses the following definitions:

M1 = Currency outside banks + Deposits of financial institutions with

Bangladesh Bank (except with deposit money banks) + Demand
deposits with deposit money banks

M2 = M1 + Time Deposits with commercial banks.

 The Monetary Base
The two liability components of the central bank – currency and
reserves – makes up what is known as the Monetary Base. It is also
known as Reserve Money, Base Money or High Powered Money.

This is the amount of money under the control of the central bank.
That is, the central bank can directly influence the monetary base
through its monetary policy instruments.

Thus we have:

Currency in circulation + Reserves = Monetary Base (High

powered money)
MB = C + R
 The Monetary Base
At this stage, before going into the details of the conduct of
monetary policy, it is important to keep in mind that the
monetary aggregates (M1 and M2) and monetary base are
not the same. Monetary base gets amplified to become
monetary aggregates through the actions (i.e., lending) of
the commercial banks.

That is, say for an example, an increase in the base money

by Tk.1 created, via the actions of the commercial banks
leads to an increase in the supply of money by more than
Tk. 1.
 Relationship between Deposit, Reserve
and CRR: The simple money multiplier
Suppose that banks do not hold any excess reserve i.e. in excess of their
required reserve. In this case, the total amount of required reserves (CRR)
for the banking system will equal the total reserves (R) in the system.

Thus, we have: CRR = R (reserve)

Let, D= deposit
r = required reserve ratio with 0<r<1

Next, we know that the total amount of required reserve is given by the
required reserve ratio r times the total amount of checkable deposits, D.
Thus, we have: R = r x D
Changing sides, D = (1/r) x R
Relationship between Deposit, Reserve and CRR: The simple money multiplier
Next, we take the change in both sides of the equation which gives us:

⇨ Change in D = (1/r) × change in R [ r is fixed]

1/r is known as the simple money multiplier.

Applying the above formula in our example,

Change in D = (1/0.1) × 100 = 1000, which is the change in the money supply

Thus,
Change in money supply = 10 × change in monetary base
If the reserves increase by Tk. 100, the checkable deposits (money) must
increase by Tk. 1000 (=10 × Tk. 100) when required reserve ratio is 0.10.

Hence the money multiplier in this example is equal to 10. In fact the increase
is by the factor of the reciprocal of the required reserve ratio.
 Money Multiplier
Now will expand the definition of money multiplier when there are
currency and excess reserve in the baking system.

The money multiplier (m) measures the change in the money supply (M)
due to the change in the monetary base (MB).

M = m × MB
m gives us what multiple of monetary base is transformed into money.

Let us define,
c = C/D = currency ratio
e = ER/D = excess reserve ratio
We know,
Total reserve R = Required Reserve (R) + Excess Reserve (ER) = r × D + ER
 Money Multiplier
Thus, Monetary Base (MB) = R + C = r × D + ER + C
=r×D+e×D+c×D
= D (r + e + c)

⇨ D = [1/(r + e + c)] × MB

Money supply (M) = C + D = c x D + D = D [1+c]

= [(1+c)/(r + e + c)] MB

Therefore, money multiplier m = (1+c)/(r + e + c)

The above formula for money multiplier sheds light on the fact that the
extent of amplification of monetary base (reserve) critically depends on
the behavior of the central bank, commercial bank and depositors.
 Goals of Monetary Policy
There are two major goals of monetary policy
1. Stabilization of price and output
2. Stabilization in the financial sector
The main objective of monetary policy is to contain inflation and
stimulate output and employment growth. Achieving the goal of
containing inflation has been found easier than impacting the
output and employment in a developing country. Sometimes it is
said about monetary policy that ‘you could pull on it to stop
inflation but you could not push on it to halt recession’.

It is important to keep in mind that supply-side shocks such as

natural disaster, political instability, international price level, etc.
contribute to the increase in price level more than the demand
shocks (i.e., drop of public confidence) in developing countries.
 Goals of Monetary Policy
Monetary policy can only impact the demand side where
demand comes from the consumers and investors. That is,
monetary policy cannot play any role in combating inflation if
the changes in price is due to supply shocks.

Impacting output and employment through the monetary policy

requires that the channels that link between policy instruments
and policy goals work perfectly and predictively. These channels
are formally known as transmission mechanism.

Unlike developed countries, transmission mechanism is very

weak in the developing countries. Therefore, setting the
monetary policy goals of impacting real economy can be very
ambitious for developing countries.
 Goals of Monetary Policy
MPS states the following two goals on inflation and economic
growth:

- Target for achieving 7.5% inflation by June 2024.

- Target of achieving real GDP growth of 6.5%-6.7% by June 2015.

Central bank as the regulatory body is also responsible to

stabilize the financial market. The regulatory role in ensuring
discipline in the market, especially in the banking sector is seen
as one of the major tasks of the central bank in developing
countries. Apart from regulatory, monitoring and supervisory
role of the central bank, monetary policy, by using tools of
monetary policy, can also have strong impact on the financial
market to ensure stability and discipline.
 Targets of Monetary Policy
Bangladesh Bank uses two types of targets – operational and intermediate target.

Operational target: High powered money (monetary base)

Operational target is the direct result of the policy action. For example, if the central
bank injects money into the economy by purchasing government bonds (i.e., open
market purchase), it can immediately impact the amount of monetary base. The
operational target is within the control of the central bank.

Can the Bangladesh Bank fully predict the growth of monetary base? Put
differently, can it hit the target level of monetary base through open market
operations?
 Targets of Monetary Policy

As we know, Monetary Base (H) = C + R

The sources of monetary base are the assets of the central bank - net
foreign asset and net domestic asset. Net foreign asset includes the
remittances and export earnings. These components are very volatile –
the growth changes from year to year considerably. The other
component of asset is the net domestic asset which is mostly central
banks’ loan to the government and commercial banks. This part also
changes substantially over time. However, the central bank can
minimize the fluctuations of monetary base due to external factors
using some measures called ‘sterilization’.
 Assets
The assets of the central banks can be divided into the broad categories of Net
Domestic Assets (NDA) and Net Foreign Assets (NFA).

Net Domestic Assets (NDA): It consists of net domestic credit and investment
in government securities.

1) Net domestic credit: It includes its credit to banks, financial institutions and also to the
employees of the Bangladesh Bank. Note that it does not include the credit disbursed by the
commercial banks. Commercial banks’ credit, which is the asset of the commercial banks, has
nothing to do with central banks’ asset.

2) Government securities: It is the net claims on government. Often the government borrows
from the central bank by issuing Treasury bonds. The central bank can also buy bonds from the
commercial banks in order to inject money into the economy. These bonds are the asset of the
central bank.
 Assets
Net Foreign Assets (NFA): the sources of net foreign assets are receipt from
export income, remittances, foreign aid, FDI, etc. Since, monetary systems used
to follow ‘Gold Standard’ where gold was the only asset of the central bank, all
central banks in the world has been historically holding a large amount of gold.
This gold standard was abandoned in 1973, following the historic Bretton Wood
agreement.

All financial assets denominated in foreign currency are primarily held in the
following forms: Foreign currency accounts, foreign investment such as
investment in US treasury bonds, gold and silver and foreign currency loan to
banks. It is interesting to note that the gold and silver deposits are kept in the
Bank of England and at the bank in Motijheel by the BB. These reserves can also
be lent by the central banks to each other.
 Assets
Now we are equipped with the two basic tools – balance sheet of commercial bank and balance sheet of
central bank – for analyzing money supply process in the economy. The key now is to establish the link
between monetary base – money the central bank creates and monetary aggregates - money that grows
from monetary base.

Before going into details of the creation of money and money supply process, we introduce another
important monetary accounting concept known as monetary survey. Monetary survey refers to the
consolidated balance sheet of the commercial banks and the central bank. First, we need to identify the
common items on the both balance sheets.
 Assets
After cancelling out the same items from both the sides of consolidated
balance sheet, we end up with the following balance sheet. Note that the
sum of all liabilities of the consolidated balance sheet is the M2 of the
economy.
 Targets of Monetary Policy
Intermediate target: Monetary aggregate (M2)
Intermediate target is the most crucial step to link the operational target with
the macroeconomic goals. The Bangladesh Bank wants to impact growth and
inflation in the short run by targeting a desired level of the growth of M2.

Remember the relationship between monetary base (operational target) and

the money supply (intermediate target). They are linked by money multiplier
and it depends on the behavior of banks (excess reserve), central bank (CRR)
and depositors (currency holding).

Therefore, if the relationship between the operational target (reserve money)

and the intermediate target (M2) is fairly stable, the central bank can
reasonably target the monetary growth. But in practice, currency demand by
the depositors and demand for excess reserve by the banks are very unstable.
 Targets of Monetary Policy
The following Figure taken from MPS shows how the growth of actual
M2 deviates from the projection.
 Instruments of Monetary Policy
CRR (Cash reserve ratio)
The fraction of deposits that the commercial banks are required to keep as
reserves with the central bank and in their vaults as cash. Currently the
CRR in our country is 4%. Let us again look at the balance sheet of a
hypothetical bank:

Suppose, there are only two assets of the bank – cash reserve and loan. For
the sake of simplicity, also assume that there is no excess reserve – all
loanable fund is loaned out. Total deposit is Taka 100 of which Taka 6 is the
required reserve (CRR is 0.6) and Taka 104 is the loan. Now suppose, central
bank raises CRR to 0.10. What will happen to intermediate target (M2)?
 Instruments of Monetary Policy

In order to meet the higher cash reserve, the bank has to cut down its loan to
Taka 100. As a result, it slows down the deposit creation process by the
banks. More formally, the size of the money multiplier will be smaller and it
will lead to slower growth of M2.

CRR = 0.06 🡺 money multiplier = 1/0.06 = 16.66

CRR = 0.10 🡺 money multiplier = 1/0.10 = 10

 Instruments of Monetary Policy
Therefore, an increase in CRR is a contractionary policy which shrinks the growth
of the money supply in the economy through lower money multiplier effect.
Changing of CRR impacts the availability of loanable fund as we see before.
Therefore, it can impact the flow of credit to the private sector and the real
economy. So, we can write the possible channels of impact as follows:

CRR ↑🡺 M2 ↓ 🡺 liquidity available for credit ↓ 🡺 private sector credit ↓ 🡺 investment ↓

CRR ↓🡺 M2 ↑ 🡺 liquidity available for credit ↑ 🡺 private sector credit ↑ 🡺 investment ↑

When the CRR is increased, banks have lesser funds that they can give out as
credit and so both private sector credit and investment declines. The opposite is
true when the CRR is decreased. Also think about when there is an excess
liquidity in the banking sector which is very common in Bangladesh. Will the two
channels described above still work?
 Instruments of Monetary Policy
In USA, CRR is hardly used because the objective of affecting interest rate can
be more effectively done with other instruments such as open market
operation. The objective of targeting the inter-bank interest rate (federal fund
rate) can be done more accurately with open market purchase than changing
CRR.

SLR (Statutory liquidity ratio)

It includes both CRR and ‘near money’ items such as bonds, treasury bills
and gold among others. Besides the CRR, commercial banks are also required
by the central bank to maintain a certain fraction of their deposits in the form
of these items.

SLR is currently 13% of total deposits in our country. By changing the SLR,
the central bank can also change the composition of asset, especially the
credit flow of the banking sector in the country as we see in the case of CRR.
 Instruments of Monetary Policy
Open Market Operations
Open Market Operations (OMO) refer to the purchase and sale of
government securities by the central bank from the commercial banks in
order to control the supply of money in the economy. The term open market is
in reference to the fact that the central bank conducts purchase and sale in an
open and competitive market.

Open Market Purchase (Expansionary monetary policy)

When the central bank purchases government bonds from the banking
sector (in exchange for money), it increases the reserve (liquidity) of the
banks. That is, the monetary base (reserve money) increases. Through
multiple credit expansion, it further increases the money supply in the
economy.
Instruments of Monetary Policy
 Instruments of Monetary Policy
Now suppose, the central bank purchases Taka 10 worth of bond from
the bank and pays the bank with cash. Therefore, after this open
market purchase, the balance sheet of the bank and the central bank
will like the following:
 Instruments of Monetary Policy

Thus, the central bank has just created Taka 10 of high powered money
(monetary base). As the bank has now more liquidity available to loan
out, it will lend it to others who will deposit to their banks and total
deposit will increase. This process continues and the amount of money
the economy ends up depends on the size of the multiplier.

Open Market Sale (Contractionary monetary policy)

When the central bank sells government bonds to the banking sector, it
draws down reserve and the monetary base. Therefore, money supply
also decreases. The open market sale is just the mirror image of open
market purchase. The central bank also suffers from lack of adequate
control over the money supply.
 How does Bangladesh Bank set the target of
reserve money and M2?
In practice, Bangladesh Bank follows the following method in setting targets
for the following six months in the Monetary Policy Statement (MPS).

a) Setting ‘safe limit’ of monetary expansion

By using simple quantity theory of money, Bangladesh Bank calculates an
approximate figure of the monetary expansion. Let us take an example.

The quantity theory of money states that

MV = PY

taking log in both sides and then first differentiating with respect to time,
m+v=p+y
 How does Bangladesh Bank set the target of
reserve money and M2?
It shows that the percentage change in money supply plus percentage change
in velocity of money is equal to the inflation and growth rate of output.

Let’s assume, p = 6.5%, v = -1.5%, y = 7%.

The velocity of money (GDP/M2), is a downward slopping curve. Recent

estimates shows that percentage decline of velocity of money is about 1.5%.

Therefore, we can calculate,

m = p + y – v = 6.5% + 7% + 1.5% = 15%

It suggests that the growth of M2 should be to the tune of 15% if GDP grows at
7% and inflation is 6.5%.
 How does Bangladesh Bank set the target of
reserve money and M2?
b) Projection of M2 from the balance sheets of the central bank and
commercial banks

We have learnt about the ‘monetary survey’ - the consolidated balance

sheets of the central bank and commercial banks which is a uniform
reporting format of the aggregate banking variables (both commercial and
central) across all countries, put forwarded by IMF. It distinguishes between
domestic and foreign assets of the commercial banks and the central bank
and add them up to get money supply (M2).

Recall NFA + NDA = M2

Change in NFA + change in NDA = change in M2
 How does Bangladesh Bank set the target of
reserve money and M2?
Projection of Balance of Payment, especially the forecast on the growth of
remittance and net export for the next six months give a strong indication of
the future growth path of NFA.

NDA has two major parts – credit to the private sector and credit to the
government. Projection on the demand for credit is made based on the current
macroeconomic situation and future outlook.

On the other hand, government’s budget deficit and its likelihood of

government borrowing from the banking sector helps estimate the possible
changes in credit to the public sector. These two projections about private and
public credit are used to calculate the target change of M2.

This target is analyzed against the ‘safe target’ derived from the quantity
theory of money.
 How does Bangladesh Bank set the target of
reserve money and M2?

c) Projection of monetary base

As we know, the money supply is linked with monetary base
through money multiplier, we can set the target level of the
growth of monetary base (H).

M2 = money multiplier x H

How open market purchase and sales are conducted?

In order to understand how open market operation works, it is
imperative to have a comprehensive knowledge on the market
of the government securities.
The market for government securities
 The market for government securities
The table above shows the issuance and auction of the various
government securities by the Bangladesh Bank in the country. They
are of different tenors (time to maturity) and hence have differing rates
of yield.

The government/central bank securities traded in our country today is

of the following three types:

 Bangladesh Bank (BB) bills,

 Treasury bills (T-Bills) and
 Treasury bonds (T-Bonds).

Bangladesh Bank (BB) bills – These bills of the Bangladesh Bank

generally have maturity of 30 days.
 The market for government securities
Treasury Bills (T-Bills) – These are the securities with maturity periods of
less than a year and currently includes the 91, 182 and 364 days T-Bills.

Bangladesh Government Treasury Bonds BGTB (T-Bonds) – These

securities have maturity periods of more than a year and currently consists
of the 2, 5, 10, 15 and 20 years T-Bonds.

Next, we discuss some terminologies related to the anatomy of

government securities which will help us understand the auction
presented in Table 1.

Tenor – refers to the time that must elapse before a security becomes due
for payment. Simply put, this is the maturity period of the security.
 The market for government securities
Range of yields – The range of yield rates for govt. securities that are bid in
by the Primary Dealers in the auction.

Cut off yield – The yield above which submitted yields are rejected while
those below are accepted in the auction process

Devolvement – Devolvement refers to fact that when a security is

undersubscribed (i.e. there are fewer bids than the offered number of
securities) during an offering, the underwriting entity has to purchase the
unsold securities. Thus, in this context devolvement entails the buying of the
unsold securities offerings by the appointed Primary Dealers (PD).

Devolvement yield – The rate of yield obtained in the case of devolvement

of the issued securities. Devolvement can be on the PDs or on the
Bangladesh Bank.
 How are the T-Bills and BGTBs issued?
Weekly (usually on Sunday) auctions of Treasury Bills are held following a
pre-announced auction calendar with a specified amount. Bidders quote
their prices. The Auction Committee determines the cut-off price from the
offered prices.

Weekly (usually on Tuesday) auction of BGTB of a particular tenor is held

following a pre-announced auction calendar with the specific amount. In
case of new issue bidders quote their expected yields and in re-issue auction
they have to quote price.

The auction process

The auction of the government securities can be either yield based or price
based.
 How are the T-Bills and BGTBs issued?
Yield Based Auction
This auction method is generally used when a new security is issued by the
government. Investors (the PDs) bid in their yield terms and the bids are
arranged in an ascending order. The cut-off yield is arrived at the yield
corresponding to the notified amount of the auction. This cut-off yield is taken
as the coupon rate for the security. Those bidders who have bid at or below the
cut-off rate are the successful ones while the bids higher than the cut-off yield
are rejected.

Price Based Auction

This method is used in the re-issue of existing government securities. Bidders
quote in terms of price per face value of the securities. The bids are then
arranged in a descending order and the bidders who have bid at or above the
cut-off price are the successful ones while bids below the cut-off value are
rejected.
 How are the T-Bills and BGTBs issued?

The minimum bid amount in an auction is Tk. 1 lac (0.1 million) and
its multiples. Apart from the PDs, individuals wishing to buy the
securities have to do so through the PDs in auction and can also
buy in the secondary market from any PDs/Banks/NBFIs. The
securities cannot be cashed in before the date of maturity but the
holders can sell them in the OTC or secondary market.

Now that we have reviewed the necessary terms and terminologies

related to the issue and auction of the government securities, let us
briefly look at a typical auction report. The information on auctions
by the BB is given in the form of bids received and accepted.
 How are the T-Bills and BGTBs issued?
For example, in the auction of the 2yr T. Bond on 04/02/2015, we have the
following information:

 A total of 25 bids were received for this security with a face value of Tk.
503.68 crore and the offered yields were in the range of 8.4-9.0%.

 From these bids, a total of 8 were accepted by the auction committee with a
face value of Tk. 278.9600 crore and within the yield range of 8.4-8.5%, implying
that the cut-off yield was set at 8.5% for this particular security in the auction.

This is how the yield rate of the securities is determined by the market through
auctions by the PDs. For BB Bills and T-Bills, the sale price is less than the face
value of the bills as the bills are sold at discount. In the situation that the
securities have to be devolved by the Bangladesh Bank, the devolvement yield
is set at the rate of the cut-off yield for the security.
 Repo (Repurchase Agreement) and Reverse Repo
These are the instruments used by the central bank for short term liquidity
management in the banking sector.

Repo is a type of short-term borrowing for dealers in government securities.

Repo involves the following: One of the parties involved in the transaction
sells the security to the other party with the promise that he will buy it back at
a certain date in the future. The buyback price of the securities will be higher
than the selling price and this constitutes the interest earned in making the
loan. This is the repo rate.

The use of securities in the process can be viewed as collateral for the loan
made. For the party that sells the security and agrees to buy it back in the
future, it is a repo. For the party at the other end of the deal that buys the
security and agrees to sell it back at a future date, it is a reverse repurchase
agreement or reverse repo.
 Repo (Repurchase Agreement) and Reverse Repo
Generally repo and reverse repo are defined from commercial banks’ point of
view.

In case of repo, the commercial banks sell government securities to the central
bank, usually on an overnight basis, and buys them back, generally, on the
following day. Its ‘tenor’ however varies from 1-7 days. Banks can borrow for
short term from the central bank to avoid default on CRR using repo. The rate
that the central bank charges the commercial banks on these short term
borrowings is the repo rate.

The opposite occurs in case of reverse repo. In a reverse repo transaction,

commercial banks purchase government securities from BB and lend money to
the central bank, thus earning interest on the loans made, which is the reverse
repo rate. Central banks mop up the excess liquidity of the banking sector
using reverse repo.
 Repo (Repurchase Agreement) and Reverse Repo
Ideally by using repo and reserve repo, the central bank can target inter-bank
interest rate. Repo injects money to the banking system and thus put a
downward pressure on the interest rate.

On the other hand, reverse repo mops up liquidity from the banking system
and puts upward pressure on the interest rates. These two forces are skillfully
used with to pinpoint the inter-bank interest rate. But in a developing country
like Bangladesh, where interest rate is not targeted, repo and reverse repo are
largely used for short term liquidity management in the banking sector.

Repo rate is the discount rate at which banks borrow from BB. Reduction in
repo rate will help banks to get money at a cheaper rate, while increase in repo
rate will make bank borrowings from BB more expensive. If BB wants to make
it more expensive for the banks to borrow money, it increases the repo rate (a
contractionary policy). Similarly, if it wants to make it cheaper for banks to
borrow money, it reduces the repo rate (an expansionary policy).
 Why repo rate is higher than reverse repo rate?
Banks are borrowing from the central bank (repo rate) at a lower rate and
lending it back to the central bank (reverse repo rate) at a higher rate!! It
simply does not make sense - there would be arbitrage opportunities for
the commercial banks allowing them to earn a free income.

Hence this cannot be true but the opposite holds as the banks will have
no incentives to do so (pay higher interest rate on loans from the central
bank than they make on their deposits with the central bank).

Generally, repo rate is 100 basis points higher than the reverse repo rate.
Basis point is a unit of measurement used for interest rates and other
percentages in finance. It is equal to 1/100 of 1% or 0.01 and is used to
denote the percentage change in a financial instrument. Thus a 1%
change is equal to 100 basis points and 1 basis point is equal to 0.01.
 Transmission Mechanism of Monetary policy
Highly developed and competitive financial market is required to
transmit the effect of any policy change by the central bank into other
markets such as markets of reserves (interbank money market) and
market for loanable funds of banks, secondary markets of short term
and long term government securities, foreign exchange market and
other asset markets such as real estate. Changes in the conditions of
these markets result in the changes in aggregate demand of the economy
to affect the real economy.

First, we will learn how the transmission mechanisms work in the context
of developed countries. This will serve as the ideal case or the benchmark
against which we will discuss these issues for a developing country like
Bangladesh.
Transmission Mechanism of Monetary policy
Transmission Mechanism of Monetary policy

• Let us assume that the central bank conducts

open market purchase and injects liquidity
into the banking system.

• With more liquidity available in the market

for inter-bank trade, it puts downward
pressure on the inter-bank interest rate.
This thing happens only when there is a high
degree of competition in the market for
reserve – banks competing with each other
for reserve.

• What about the market for reserve in

Bangladesh? How competitive is it? In most
of the time, with huge idle excess liquidity,
there is hardly any competition among banks
for extra liquidity.
Transmission Mechanism of Monetary policy

• As the inter-bank interest rate goes down,

the competitiveness in the credit market
also pushes down the lending rate. That is,
if one bank does not lower lending rate,
other banks would do and grab the market
since money is now available at cheaper
rate in the inter-bank market. This is
known as the credit channel of the
transmission mechanism.

• The credit channel of a developing

country may be different from that of a
developed one. Instead of working
through lowering lending rate, the
channel may work through making
greater availability of credit for business.
Transmission Mechanism of Monetary policy

• Lower inter-bank interest rate also pushes

down other short term interest rate such
as T-bills.

• Suppose in the short run, say one month,

banks have two options for investment –
T-bills and short-term lending to other
banks. If the inter-bank lending rate goes
down, banks will be more willing to buy
T-bills.

• As a result, demand for T-bills will rise

and so does price. This leads to a decrease
in yield (interest) of T-bills too. This is the
interest rate channel (short term) of the
monetary transmission mechanism.
Transmission Mechanism of Monetary policy
• This lower short term interest rate also
exerts downward pressure on the long
term interest rate such as T-bonds, long
term business loans, etc.

• We know that long term interest rates

are generally higher than the short term
interest rates and they are highly
correlated. While short term interest
rate affects mostly household behavior,
long term interest rate impacts
investment decision of the firms. This is
the long term interest rate channel of
the transmission mechanism.
.
Transmission Mechanism of Monetary policy

• Long term interest rates are generally

used as the discount factors to estimate
the future stream of income from an asset
of long maturity such as real estates.
Therefore, prices of such assets depend on
the long term asset. This is the asset
channel of the transmission mechanism.

• Lower domestic interest rate of short term

government securities also impacts
foreign short term interest rates under
perfect capital mobility and flexible
exchange rate.
Transmission Mechanism of Monetary policy

• As the short term interest rate gets lower,

capital flows from domestic to foreign
countries. That is, people will buy foreign
government securities which gives higher
interest rate than the domestic one.

• This will also increase the demand for

foreign currency and will lead to
exchange rate depreciation for the
domestic country. It will boost exports
and impact the real economy. This is the
exchange rate channel of the transmission
mechanism.