Monetary
policy in developing economies mainly includes five major macro
variables: output growth, inflation, interest rate, exchange rate, and
money supply. The success of monetary policy hinges on a skillful
interaction of these variables by the central bank. A pictorial
presentation of a star usually features five corners where five major
variables related to monetary policy can be placed and hence the star
model of monetary policy has been coined in this article. If we connect
all the corners with outer lines, the star turns into a pentagon without
changing the essence of the model that describes the inter connectivity
of the major variables of monetary policy.
The variables fall
into three different levels: operational, intermediate and final. Money
supply and interest rates are often used as operating targets to
influence the intermediate targets such as inflation and exchange rates.
Economic growth is the final target whose rise increases employment and
thus reduces unemployment and poverty.
That is how monetary
policy works in developing countries like Bangladesh. However,
level-wise demarcation is not always effective. Operating and
intermediate targets may change their places based on the preferences of
the central bank. Sometimes the exchange rate, as an operating target,
is used to steer inflation.
Sometimes inflation steps up from the
intermediate level and becomes a final target along with output growth.
In 1923, Keynes asserted that price stability is the main objective of
monetary policy. But prices may remain stable along with a poor
performance in growth. So, most developed nations adopted the dual
mandate of monetary policy that targets maximum employment and low
inflation. Since developing countries lack the data on employment,
growth is used as a proxy for employment. The higher the growth the
higher the level of employment or the lower the level of unemployment.
Emerging
economies like Bangladesh and India assign moderate inflation and
respectable growth as the dual mandate of monetary policy. While
developed countries target 2 percent to 3 percent inflation, the
desirable number for a developing country can be between 3 percent and 5
percent. Empirically, these ranges of inflation can support output
growth between 2 percent and 4 percent for the developed nations and
between 5 percent and 10 percent for developing nations. Keeping these
two prime targets of inflation and growth in mind, the central bank
formulates monetary policy which becomes challenging because growth is
often inflationary.
For example, the positive correlation between
growth and inflation in Bangladesh has been 45 percent over the period
since liberalisation of the early 1990s. When an economy is growing,
wages rise because business firms hire more people or demand extended
work hours from the existing employees. Thus, higher wages push
inflation further upward. This is simply the bottom line of the Phillips
curve.
Who cares about inflation if growth, which we care most,
is commendable? Actually, that is not the case. Higher inflation at some
point will act like a mythological monster -- high inflation will eat
up growth potentials through reduced consumption and twin deficits (both
fiscal and trade deficits). That was the destiny of most Latin American
countries for decades when hyperinflation drastically eroded their
growth momentum.
If
a central bank exercises monetary targeting, we start from the bottom
level of the star model. Monetary expansion or higher money growth
reduces the interest rate, because more funds are now available to be
disbursed.
As a result, the price of fund or the interest rate
will slide down, inducing more entrepreneurs to invest. This
transmission mechanism raises output and thus GDP growth. If the economy
is open, lower interest rates will pull the exchange rate down,
improving the trade balance and output -- because exports are now
cheaper, imports costlier. That is why a country with adequate economic
openness enjoys the dual channel of growth following any monetary
expansion.
But the game is not over, if money growth is
excessive, it pushes the price level too high. Then inflation takes a
toll on growth. High inflation will raise the real effective exchange
rate and worsen the trade balance. In the domestic front, higher
inflation will make consumption expensive and will also raise the
lending rate as asserted in the Fisher equation. Investment will shrink
and growth will lose its steam. Thus, the variables in the star model of
monetary policy may change interrelationships based on the direction of
causality. The model, however, encapsulates the story of dynamics
involving the major elements of monetary policy in developing countries.
