Monetary targeting for price stability in Bangladesh: How stable is its money demand function and the linkage between money supply growth and inflation?

Abstract

Since the mid-1980s Bangladesh has implemented a loose form of monetary targeting under two exchange-rate régimes: a pegged system until May 2003 and a ‘managed floating’ exchange-rate system. Under both régimes, broad money has been used as an intermediate target to maintain price stability, which implies as the ultimate goal a relatively low and stable rate of inflation. Inflation in this country has, however, remained moderately high and volatile, especially during the 1970s under the pegged exchange-rate system. With the apparent ineffectiveness of the monetary-targeting system in achieving price stability, even following the 2003 ‘managed float’ of the currency, there has been some suggestion that it should be replaced by, say, inflation targeting. This paper forms an element of a fuller study of the issue. It investigates the behaviour of broad money demand in Bangladesh using annual data over the period 1973–2008. Empirical results suggest that an open-economy broad money demand function has remained stable in Bangladesh since the early 2000s. Empirical results also suggest the existence of a causal relationship between money supply growth and inflation. The paper concludes that, although monetary targeting remains appropriate for Bangladesh, its implementation can be made more effective in stabilising the price level if the Bangladesh Bank enhances its control over the money supply by eschewing nominal exchange-rate stabilisation through foreign exchange market interventions.