Macro-Economics

Course Code :
eco 205

Term Paper
Topic :
Increase of
interest rates
and it’s effects
on inflation
control in

Banglades
h:A
Group : two
Monetary
Policy Review
Accounting and Information Systems

Course Code: ECO 205

Course Title: Macro-Economic

SL No. Student Name Student ID

1 Group Leader - Shotorupa Rani 2112433112

2 MD Imran Miah 2111133113

3 HRIDOY MOZUMDER 2110433114

4 Shourov Das 2110833116

5 Md.Bokul Ali 2110433117

6 Md.Hadaytul Islam 2110333118

7 MIA RAFIN RAHMAN 2110333119

8 MD Mubin 2010733158
 Increase of interest rates and its effects on inflation
control in Bangladesh: A Monetary Policy Review

In Asia, Bangladesh is one of the hardest hit countries by the current wave
of inflation and oil prices. The economy has been observing high inflation
growth on a point-to-point basis since July 2007.

The rising rate of inflation and frequent change in interest rate has become
a serious problem for Bangladesh in recent years. The prices of essential
commodities have increased significantly, and so has the cost of living. The
continuous fall of the stock market is another major concern for
Bangladesh.

An increase in interest rates has a significant impact on the economy of

Bangladesh. In the situation of inflation, the interest rate is increased to
control and cope with inflation. When the central bank increases interest
rates, it generally aims to reduce inflationary pressures by discouraging
borrowing and spending. A higher interest rate usually slows down the
economy.

Definition of inflation
By inflation, in ordinary language, we mean a process of raising the prices
of goods, products and commodities. An inflationary situation occurs when
there is a rise in either the prices of products and commodities or the
supply of money which is not used or invested in production purposes.
Usually in practice, both rise at the same time.
In the Keynesian sense, true inflation begins when the elasticity of the
supply of output in response to an increase in money supply has fallen to
zero or when the output is irresponsive to change in the money supply. In
case of a situation of full employment (if exists), the conditions will be
inflationary.

Inflation = Current Demand – Demand needed to purchase the product

Causes behind inflation
There are many causes behind inflation. The important causes are given
below:

1. Deficit Financing: Govt. needs to make deficit financing for

development work. When govt. issue notes or credit for this purpose, then
the price level increase.

2. Extension of credit by commercial banks: When the central bank

takes steps in favour of granting credit, then commercial banks can grant
loans on a large scale. As a result, the supply of money increases but
production does not increase at the same rate so it creates inflation.
3. Cost of war: At the time of war, govt. has to spend extra money. As a
result, the supply of money increases. But this money is not used for
production. So, it creates inflation.

4. Extension of circular of money: If the tendency to expend money

increases, then the price level increases and it results in inflation.

5. Natural Calamity: When natural calamity occurs, it hampers the

production. So, the product price increases and inflation occurs.

6. Impact of trade union: Trade union always tries to increase the wage of
labour. If the owners increase the wage according to the trade union it
increases the production cost and the price of the product increases which
ultimately leads to inflation.

7. Increase in population: The population is increasing rapidly. But the

increase in production isn’t proportionate to the rising population. Hence
there isn’t enough supply against the increasing demand. So, it slowly
creates inflation

8. Impact of indirect tax: If govt. imposes an excessive indirect tax on

products, then the prices of products are increased and inflation occurs.

9. Fake crisis: Some dishonest businessmen store products on a large

scale and create fake crises/shortages of goods/products. As a result,
inflation occurs. It is one of the major causes of inflation in Bangladesh.

10. Others: The following causes are mainly responsible for inflation:
i) Reduction of production
ii) Smugglings
iii) Increase in production cost
Types of Inflation
1. Demand-pull inflation: When the increasing pressure of aggregate
demand of goods and services exceeds the available supply of output and
thus increases the price level is called demand-pull inflation.

It represents a situation where the aggregate demand cannot be met by the

available supply of output. For example: In a situation of full employment,
the govt. expenditure or private investment goes up. The situation is bound
to generate pressure on the economy.

Demand-pull inflation can be illustrated with the help of ordinary demand

and supply curves.

In this figure, AS represent the aggregate supply which rises upward at the
beginning. At full employment level A, the curve takes a vertical shape. This
is because after the level of full employment.
2. Cost-push inflation: When there is a general increase in the price level
due to the increase in the cost of production, is called cost-pushed inflation.
Production costs may increase because of various reasons like-

 Increase in the price of production factors

 Increase in the price of raw material
 Increase in transportation cost
 Increase in interest rate

Because of these reasons, production cost increases. And the price of

products increases, which leads to inflation.

Cost pull inflation can be illustrated by aggregate demand and supply curve

In this figure, at first, the equilibrium price level P is determined at the

intersecting point (F) of YS. So the output is determined as Y.

Because of the increase in cost, the curve moved from F and went to the
intersection points of P1 and F1 and P2 and F2 respectively. So, the price
increased to P1 and P2.
This type of price increase is called cost-push inflation.

3. Hyperinflation: hyperinflation is generally defined as price increases of

50% or more per month, but in worst-known cases, prices have doubled in
days or hours. Hyperinflation happens only when people lose all confidence
in a government and its institutions, usually in the aftermath of political or
economic upheaval.

Monetary policy

Monetary policy refers to the actions and measures taken by a central bank
or monetary authority to manage and control the money supply and interest
rates in an economy. The primary goal of monetary policy is to achieve
price stability, promote economic growth, and maintain financial stability.

Here are some key concepts related to monetary policy

1. Money supply: The central bank influences the money supply by

controlling the amount of money in circulation. It can increase the
money supply by purchasing government securities or lowering
reserve requirements for banks. Conversely, it can decrease the
money supply by selling securities or increasing reserve
requirements.

2. Interest rates: Central banks use interest rates as a tool to influence

borrowing costs, spending, and investment in the economy. They can
increase interest rates to reduce borrowing and control inflation or
decrease interest rates to encourage borrowing and stimulate
economic activity.
 3. Open market operations: Central banks conduct open market
operations by buying or selling government securities in the open
market. When the central bank buys securities, it injects money into
the economy, increasing the money supply. When it sells securities, it
absorbs money from the economy, reducing the money supply.

4. Reserve requirements: Central banks require commercial banks to

hold a certain percentage of their deposits as reserves. By adjusting
reserve requirements, the central bank can influence the amount of
money banks can lend, impacting the money supply.

5. Quantitative easing (QE): In times of economic crisis or recession,

central banks may implement quantitative easing. This involves
buying long-term government bonds or other financial assets to inject
liquidity into the economy, lower long-term interest rates, and
stimulate lending and investment.

6. Inflation targeting: Many central banks adopt an inflation-targeting

framework as part of their monetary policy. They set a specific
inflation target, such as 2%, and adjust interest rates or other policy
tools to achieve that target.

7. Forward guidance: Central banks provide forward guidance by

communicating their future policy intentions to guide market
expectations. This helps shape market reactions and provides clarity
to businesses and investors

It's important to note that the specific tools and strategies used in monetary
policy can vary between countries and central banks, depending on their
economic circumstances, policy objectives, and institutional framework.
 Monetary policy of Bangladesh Bank

The Bangladesh Bank is the central bank of Bangladesh and is responsible

for formulating and implementing monetary policy in the country. The
monetary policy of the Bangladesh Bank is guided by its primary objective
of maintaining price stability and supporting sustainable economic growth.
Here are some key features of the monetary policy of the Bangladesh Bank

1. Inflation targeting: The Bangladesh Bank follows an inflation

targeting framework, with a specific inflation target set by the
government. The target aims to keep inflation within the desired
range to maintain price stability in the economy.

2. Policy interest rates: The Bangladesh Bank determines the policy

interest rates to influence borrowing costs and overall economic
activity. The two main policy rates are the Repo rate and the Reverse
Repo rate. The Repo rate is the rate at which banks borrow from the
central bank, and the Reverse Repo rate is the rate at which they
deposit funds with the central bank.

3. Open market operations: The Bangladesh Bank conducts open

market operations by buying or selling government securities in the
secondary market. These operations help regulate the money supply
in the economy.

4. Reserve requirements: The Bangladesh Bank sets reserve

requirements for banks, which determine the proportion of their
deposits that banks must keep as reserves. Adjustments in reserve
 requirements affect the amount of money that banks can lend,
impacting the money supply.

5. Prudential regulations: The Bangladesh Bank implements

prudential regulations and guidelines to ensure the stability and
soundness of the banking sector. These regulations include capital
adequacy requirements, risk management standards, and measures
to prevent money laundering and financing of terrorism.

6. Exchange rate management: The Bangladesh Bank also intervenes

in the foreign exchange market to manage the exchange rate of the
Bangladeshi Taka against other currencies. It aims to maintain a
stable and competitive exchange rate to support export
competitiveness and overall economic stability.

7. Financial sector development: The Bangladesh Bank plays a role

in developing and regulating the financial sector in the country. It
implements policies and initiatives to enhance financial inclusion,
promote access to finance, and strengthen the stability of financial
institutions.

It's important to note that the specific details and strategies of the monetary
policy of the Bangladesh Bank may evolve based on economic conditions
and priorities set by the central bank.
Interest rates

Interest rate is the amount charged over and above the principal amount by
the lender from the borrower. In terms of the receiver, a person who
deposits money to any bank or financial institution also earns additional
income considering the time value of money, termed as interest received by
the depositor.

Bangladesh bank

Bangladesh Bank is the central bank of Bangladesh. It is a symbol of the

financial sovereignty and stability of our country. Bangladesh Bank is an
institution which is responsible for safeguarding the financial stability of our
country. It holds the ultimate reserve of the nation, controls the flow of
purchasing power- whether currency or credit and acts as a banker of the
state.

Inflation Scenario in Bangladesh

Experience of high inflation is not new in Bangladesh. The country
experienced a significant rise in the inflation rate in the recent past. Table 1
summarizes the inflation scenario of Bangladesh for the last decade.
General, Food & Non-food Inflation Rate in Bangladesh from FY 2001
to FY 2011:

Year General (%) Food (%) Non-Food

(%)
Point-to- Monthly Monthly Monthly
Point Moving Moving Moving
Average Average Average
2000 - 1.94 1.39 3.04
2001 - 2.79 1.63 4.61
2002 3.58 2.79 1.63 4.61
2003 5.03 4.38 3.46 5.66
2004 5.64 5.83 6.92 4.37
2005 7.35 6.48 7.91 4.33
2006 7.54 7.16 7.76 6.40
2007 9.20 7.20 8.11 5.90
2008 10.16 10.06 11.43 7.35
2009 4.60 5.51 7.9 4.2
2010 7.61 7.52 9.9 3.9
2011 11.91 9.76 13.90 4.32

In Bangladesh, the average inflation in fiscal year (FY) 2000 was 1.94%
while it is found 9.76% in FY 2011. But during these years changes in
inflation did not follow any
monotonic pattern. Bangladesh faces a tougher challenge in bringing down
this burgeoning inflation. The latest Bangladesh Bureau of Statistics (BBS)
data shows that inflation had increased to 11.97% in September 2012, the
highest in 10 years. Food inflation, which was 12.7% in August, had
increased to 13.90 % in September while food inflation in urban areas
increased to 14.69 % in the same month from 12.94 % in August.

How central bank control inflation by increasing interest rate

Inflation refers to the rate at which prices for goods and services rise.
Interest rates the amount of interest paid by a borrower to a lender are set
by the Central Bank called Bangladesh Bank in Bangladesh.

In general, as interest rates are lowered, more people can borrow more
money. The result is that consumers have more money to spend, causing
the economy to grow and inflation to increase.

But the Central Bank usually increases interest rates when inflation is
predicted to rise significantly above its inflation target. If Bangladesh Bank
increases the interest rate this means it discourages people from borrowing
and saving. people who want to get a loan from a bank have to spend more
money on interest payments for this. And those who want to deposit money
can get more money as a form of income because of higher interest rates.

The result! There is a shortage of money in the market and consumers

have lower money to spend. So the aggregate demand will decrease. As a
result, the price will also decrease. In this way, the central bank can control
this inflation.
 Effects of Interest Rate Change

Effects of Higher Interest Rate

Higher interest rates increase the cost of borrowing and reduce disposable
income. Higher interest rates tend to reduce inflationary pressures and
cause an appreciation in the exchange rate.

Increased return to savings: If Bangladesh Bank increases interest rates,

it makes it more attractive to save in a deposit account because of the
interest gained. Therefore higher interest rates increased the incentive to
save rather than spend.

Increased cost of borrowing: Higher interest rates increase the cost of

borrowing. Interest payments on credit cards and loans are more
expensive. Therefore this discourages people from borrowing and
spending. It also reduces disposable income because they spend more on
interest payments.

Higher mortgage interest payments: When the interest rate is high,

interest payments on variable mortgages will also increase. This will have a
significant impact on consumer spending. This is because a 0.5% increase
in interest rates can increase the cost of a £100,000 mortgage by £42 per
month.

Government debt interest payments increase. Higher interest rates

increase the cost of government interest payments. This could lead to
higher taxes in the future.

Appreciation in the exchange rate: Higher interest rates increase the

value of a currency. For example - if UK rates are higher than other
countries, investors are more likely to save in British banks. A stronger
Pound makes UK exports less competitive and helps to reduce exports and
increase imports.

Effects of Lower Interest Rate

Lower interest rates make it cheaper to borrow. This tends to encourage
spending and investment. This leads to higher aggregate demand (AD) and
economic growth. This increase in AD may also cause inflationary
pressures.

Heightened economic activity: When interest rate is low, it often leads to

heightened economic activity -like people borrowing money at a lower cost.
So they tend to spend more. lower rate helps to boost the economy and
create more jobs.
Reduce the incentive to save: If Bangladesh Bank reduces interest rates,
it makes it relatively less attractive to save money in Bangladesh because
one could get a better rate of return in another country.

Lower mortgage interest payments: A fall in interest rate will reduce the
monthly cost of mortgage interest payments. This will leave householders
with more disposable income and should cause a rise in consumer
spending.

Rising asset prices. Lower interest rates make it more attractive to buy
assets such as housing. This will cause a rise in house prices and therefore
rise in wealth. Increased wealth will also encourage consumer spending as
confidence will be higher.

Depreciation in the exchange rate: If Bangladesh Bank reduces interest

rates, it makes it relatively less attractive to save money in BD because
one could get a better rate of return in another country. Therefore there will
be less demand for the BDT, causing a fall in its value. A fall in the
exchange rate makes exports more competitive and imports more
expensive for Bangladesh. This also helps to increase aggregate demand.

The interest rate set by Central Bank called the base rate has an impact on
aggregate output. If the interest rate is perfect it keeps output growth high.
On the other hand, a lower interest rate reduces output growth in most
cases by creating an economic recession. Unemployment and Interest
rates are usually inversely related. That means, when unemployment is
high the central bank often chooses to keep interest rates low, hoping
businesses will find the availability of low-interest loans an incentive to
invest in their businesses, which in turn will hopefully increase the number
of available jobs and decrease unemployment.

Conversely, when the unemployment rate is low, The Central Bank may
move to increase interest rates to avoid inflation.

Limitations of interest rate adjustments.

Central banks play a crucial role in managing a country's economy, with

one of their key tools being the adjustment of interest rates. Interest rates
are a powerful tool for influencing economic activity, investment, and
inflation. However, it is important to acknowledge that central banks face
certain limitations when it comes to the effectiveness and impact of interest
rate adjustments.

A central bank can influence interest rates by changing the discount rate.
The discount rate (base rate) is an interest rate charged by a central bank
to banks for short-term loans. For example, if a central bank increases the
discount rate, the cost of borrowing for the banks increases. Subsequently,
the banks will increase the interest rate they charge their customers. Thus,
the cost of borrowing in the economy will increase, and the money supply
will decrease.

Adjusting interest rates is a widely used tool in monetary policy, but it has
certain limitations and challenges. Some key limitations of interest rate
adjustments are described below.
1. Lags in Policy Implementation: Another significant constraint faced by
central banks is the presence of time lags in policy implementation.
Adjustments made to interest rates typically take time to filter through the
economy and have their intended effects. Recognizing the lag between
policy action and its outcomes is crucial because economic conditions and
expectations can change during this time. In rapidly evolving economic
environments, delayed responses can reduce the efficacy of interest rate
adjustments and limit the central bank's ability to address immediate
challenges.

For instance. A central bank may decide to raise interest rates to curb
inflationary pressures. However, there may be a considerable lag between
the policy decision and the actual effect on inflation. During this time,
inflationary pressures can persist or even worsen, reducing the
effectiveness of the interest rate adjustment.

2. Zero Lower Bound:

The zero lower bounds (ZLB) on interest rates pose a significant limitation
for central banks. When interest rates are already or near zero, their scope
for further reductions is constrained, limiting the traditional effectiveness of
monetary policy. This situation can occur during periods of economic
recession or when deflationary pressures are present. At the ZLB,
unconventional measures, such as quantitative easing or forward guidance,
become necessary tools for central banks to stimulate the economy and
overcome the limitation imposed by low or negative interest rates.
For example, this limitation became particularly evident during the global
financial crisis of 2008 when some countries encountered the zero lower
bound and had to resort to unconventional monetary policy measures.

3. Heterogeneous Economic Structure:

Economies are complex and diverse, comprising various sectors,

industries, and regions. Central banks often implement monetary policy at a
national level, assuming a uniform impact across the entire economy.
However, the actual effects of interest rate adjustments can differ
significantly across different sectors and regions due to varying levels of
sensitivity to interest rates. This heterogeneity makes it difficult for central
banks to achieve a targeted impact on specific sectors or regions, leading
to unintended consequences and potential imbalances.

For instance, lowering interest rates may encourage borrowing and

investment in sectors such as housing and construction, while having a
limited impact on industries with low sensitivity to interest rates, such as
healthcare or education. This heterogeneity can lead to sectoral
imbalances and unintended consequences.

4. Global Interconnectedness:

In an increasingly interconnected global economy, domestic interest rate

adjustments can be influenced by external factors. Central banks need to
consider the impact of international capital flows, exchange rate
movements, and global financial conditions when making interest rate
decisions. External shocks and spillover effects from other economies can
limit the effectiveness of interest rate adjustments and complicate the task
of achieving desired outcomes.

Changes in interest rates by one country's central bank can have spillover
effects on other countries through capital flows and exchange rate
adjustments.

For instance, if a country raises interest rates to attract capital inflows, it

may inadvertently lead to currency appreciation in other countries, affecting
their competitiveness in international trade. The global interconnectedness
of economies can limit the control central banks have over domestic
interest rates.

5. Effectiveness of Monetary Policy Transmission:

One of the primary limitations of interest rate adjustments lies in the

effectiveness of monetary policy transmission. While central banks can set
interest rates, the transmission of these changes to the wider economy is
not always direct or immediate. Factors such as financial intermediation,
banking sector health, and the responsiveness of market participants can
hinder the smooth transmission of policy adjustments. Consequently, the
desired impact on borrowing costs, spending, and investment may be
delayed or diluted.

For instance, When a central bank lowers interest rates to stimulate

borrowing and investment, the impact may be less effective if banks are
reluctant to pass on the rate cuts to borrowers due to concerns about their
financial stability. In such cases, the intended transmission of monetary
policy to the real economy is impeded.
6. Financial market distortions:

Frequent or abrupt interest rate adjustments can introduce volatility and

uncertainty in financial markets. Sudden changes in interest rates can
disrupt asset prices, exchange rates, and investor expectations. Excessive
market volatility can have unintended consequences and potentially
destabilize the financial system, which may have broader implications for
the overall economy.

For instance, prolonged periods of low interest rates can incentivize

excessive risk-taking and asset price bubbles, as investors search for
higher returns. These distortions can potentially lead to financial instability
and the buildup of systemic risks within the financial system.

7. Unintended consequences on fiscal policy:

Adjusting interest rates may have unintended consequences on fiscal

policy. Higher interest rates increase the cost of government borrowing,
potentially putting pressure on government budgets and limiting fiscal
flexibility. Moreover, if interest rate adjustments lead to a slowdown in
economic activity, it can impact tax revenues and government spending,
affecting overall fiscal sustainability.

For instance, when interest rates are lowered to stimulate economic

activity, it may lead to increased government borrowing costs if the
government needs to issue debt. This can potentially strain fiscal budgets
and complicate the overall policy framework.
8. Political and public perception challenges:

Interest rate adjustments can be politically sensitive and subject to public

scrutiny. Central banks often face challenges in effectively communicating
their monetary policy decisions and objectives to the public.
Misunderstandings or misperceptions about the central bank's intentions
can create uncertainty and undermine the effectiveness of interest rate
adjustments.

For example, in a country experiencing an economic downturn and high

unemployment rates, the central bank decides to lower interest rates to
stimulate borrowing, investment, and overall economic activity. However,
due to political and public perception challenges, the effectiveness of this
interest rate adjustment becomes limited.

In conclusion, To mitigate some of these limitations, central banks

often employ a combination of monetary policy tools and strategies. These
may include forward guidance, open market operations, reserve
requirements, and macroprudential policies. By diversifying their policy
toolkit, central banks can enhance their ability to address various economic
challenges and achieve their policy objectives more effectively.