A Report of Macroeconomics

Dapartment of MarketingUniversity of Dhaka

A Report On

InflationinBangladesh

Dr. Samir Kumar SheelAssociate Professor,Department of Marketing,University of Dhaka.

Md. Samsul ArifinNoah’s ArkBatch: 16th Roll: 43Department of Marketing,University of Dhaka

Submitted to

Submitted by

First of all I would like to thank the Almighty for giving me the strength, and the aptitude to complete this report within due time. I am deeply indebted to our course teacher Dr. Samir Kumar Sheel for assigning us such an important topic named “Inflation in Bangladesh”. I also express the depth of my appreciation to our honorable course teacher for his suggestion and guidelines, which helped us in completing this report.

Inflation is one of the major factors of macro economics. Losing the purchasing power and increasing the cost of production indicates the high rate of inflation. Inflation has both positive & negative effects depending on the situation. If we analyze the economic condition of our country, it is clear that inflation is higher in recent years comparing with past decade. Inflation fluctuates all the time because of the fluctuation of the money supply. But in recent years, we came to know that international affairs are influencing to increase the inflation rate. Consistent budget deficit and exchange rate deteriorate the economic growth which directly relates to inflation.

Executive Summary

Inflation in Bangladesh

IntroductionThe rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling, is called inflation.

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”.

Definition of Inflation rate (consumer prices)This entry furnishes the annual percent change in consumer prices compared with the previous year’s consumer prices.The inflation rate is the percentage rate of change of a price index over time.

Types of InflationThere are two primary types of inflation:

(i) demand-pull inflation(ii) and cost-push inflation.

Understanding which type of inflation is occurring at any given point in time is important if policymakers want to respond appropriately. The two types of inflation are not mutually exclusive, so it is possible for both to occur simultaneously. Left untreated, inflation can cause a wage-price spiral or even hyperinflation.

Demand-pull inflation: Demand-pull inflation occurs when spending on goods and services drives up prices. Demand-pull inflation is fueled by income, so efforts to stop

it involve reducing consumer's income or giving consumers more incentive to save than to spend.

Demand-pull inflation persists if the public or foreign sector reinforces it. Low taxes and profligate government spending exacerbate demand-pull inflation. A failure of the central bank to reign in the money supply also makes the demand-pull inflation worse.

Demand-pull inflation can spread across borders as well. China and India's economic growth not only puts pressure on prices in these countries but also on prices worldwide as the demand for imports increase.

If government spending is financed by printing currency or by the central bank monetizing the debt, demand-pull inflation can become hyperinflation. Hyperinflation is defined as annual inflation of 100% or greater. All cases of hyperinflation have been accompanied by the government or central bank issuing too much money.

Cost-push inflation: Cost-push inflation occurs when the price of inputs increases. Businesses must acquire raw materials, labor, energy, and capital to operate. If the price of these were to rise, it would reduce the ability of producers to generate output because their unit cost of production had increased. If these increases in production cost are relatively large and pervasive, the effect is to simultaneously create higher inflation, reduce real GDP, and increase the unemployment rate.

You might recognize this combination by another name, stagflation. In the 1970s, OPEC cut oil production, which led to much higher energy prices along with double-digit inflation and unemployment. Because producers faced higher operating costs, they reduced output. Relative to the demand for their products, the supply decreased, which resulted in cost-push inflation.

If cost-push inflation has a bright side, it is the fact that it is self-limiting. Cost-push inflation is associated with decreases in GDP. The decreased GDP and resulting high unemployment helps to bring producer prices back down. The trick to combating cost-push inflation is realizing that it is not demand-pull. The policy prescription for each is different, and applying the wrong prescription can create more problems than it solves. It is the unemployment issue that usually spurs policymakers to action.

If they respond to the increased unemployment by increasing spending, the inflation problem is made worse. A wage-price spiral can result if the policy responses create more demand for goods and services at the same time that unit costs are rising. By way of analogy, the prescription for a grease fire is different from that of a forest fire. Grease fires are put out by removing the source of oxygen, while a forest fire is extinguished with water. If you pour water on a grease fire, then things only get worse. This is what happened in the 1970s. Instead of letting cost-push inflation run its natural course, the Fed poured money on it, and inflation worsened.

Effect on the economy

General EffectAn 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 is 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%.

Negative EffectHigh 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 longterm.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 EffectPositive effects include ensuring central banks can adjust nominal interest rates (intended to mitigate recessions), and encouraging investment in non-monetary capital

Effects of Inflation

General Negative Positive

projects. It puts impact on Labor-market adjustments, Room to maneuver, Mundell-Tobin effect, Instability with Deflation etc.

Causes behind inflationIn 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 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 causes to face which cover both theories depending on a number of factors. These are given below-Excess of moneyInflation 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 costAnother 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.

International lending & national debtInflation 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 taxesFinally, 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.

WarWars 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.

Causes of inflation in BangladeshECONOMISTS, policy makers and multilateral capital donors have different explanations about the causes of inflation in countries like Bangladesh. A brief look at a few of such explanations merits attention for shaping and re-shaping of appropriate policies to help curb inflation. Here below is a brief critical overview of such explanations.

1. Increasing food prices in the international market: One of the causes of inflation, explained as such, relates to food prices in the international market. Bangladesh being a food importing country, any rise in food prices in the world market can push up the domestic prices of those commodities. In the not too distant past, the prices of essential commodities, like rice, wheat and edible oil, increased significantly in the international markets. So, domestic prices of those items shot up phenomenally then.

2. Excess demand resulting in demand-pull inflation: The link between rising prosperity and inflation is sought to be proved by many. Despite all its problems, Bangladesh has been performing well, in terms of economic growth over the last 10 years. Its gross domestic product (GDP) base is not small, in absolute volume terms. It is the 50th largest economy in a sample of 177 countries. Not many developing countries have grown faster than Bangladesh with bigger GDP volumes since the early 1990s. Those who seek to link inflation and GDP growth performance state that the high growth rate of GDP

and the per capita GDP in particular has led to the creation of excess demand in the Bangladesh economy. This has resulted in a demand-pull inflation.

3. Excessive supply of the money: There is the growth of money supply that is directly related to the price situation. ‘Inflation is a monetary phenomenon’, so is explained by a good number of economists as well as some of the donor agencies. It is, thus, stated to be caused by the excessive supply of money in the economy. Bangladesh Bank has otherwise been found to be guided by the monetarist approach to inflation and that is not without some good reason. If has been following a rather “cautious” monetary policy. Many consider it as a pragmatic step.

4. Increasing fuel prices: Fuel price is yet another factor that is cited to have a major impact on the domestic price situation. If the fuel prices go up, that impacts the prices of commodities through two major channels: the high prices of fuels lead to high cost for irrigation, which raises the cost of agricultural production; and, high fuel prices increase the cost of transportation, which also raises the prices of essential items transported from remote villages to urban areas.

5. Non-competitive market forces: The non-competitive market features or what are stated to be “the syndicate” syndrome –are otherwise widely considered as being one of the strong factors, igniting price pressures. Here, argument is made about many middle-men, wholesalers and importers acting as syndicates and causing large price hikes, by making cartels and hoarding essential goods like rice, wheat and edible oil. Such cartels do reportedly fix the prices of these goods, dictate supply in the market, and earn excess profits.

6. Other factors: There are many other factors behind the rising trend of inflation in Bangladesh. Such factors contribute, in their own way, to the price-hike of essential items. A detailed analysis of the situation is, thus, called for, in order to help devise a strategy for combating inflation effectively.

Lists of Inflation Rate from 1991-2010Year Inflation Rate

(Consumer Price)Year Inflation Rate

(Consumer Price)

1991 8.0 2001 5.81992 3.8 2002 5.81993 3.0 2003 3.11994 3.5 2004 5.61995 8.8 2005 6.01996 7.0 2006 7.0

1997 2.6 2007 7.21998 7.0 2008 9.11999 9.0 2009 8.92000 9.0 2010 5.4

Source:(1) CIA World Factbook.(2) Bangladesh Bank.(3) Bangladesh Bureau of Statistics.

Historical Trend AnalysisThe government introduced policy and institutional reforms encompassing the fiscal, financial, exchange rate, trade and industry, public resource management and public enterprise sectors. But some of those measures were not strongly pursued and some of the intended structural reforms were postponed. Monetary control in the initial years had a positive impact on the control of inflation.The regarded decision are taken below-

To increase investible funds with the banks, the minimum cash reserve requirement and statutory liquidity requirement were reduced gradually from 8 and 23 per cent respectively on 25 April 1991 to 5 and 20 per cent respectively. This decision has reduced the inflation rate.

In 1991 the lending rate was 14.99 which was high during 1992 but then it started to be reduced at 14.39 (1993) and 12.22 at 1995.

With the flexible use of the monetary instruments, broad money growth (Money Supply) was brought down from high rates of growth (14.1 percent) in the mid-1992 to 10.6 per cent in June 1993 to reduce the rate of inflation.

In the year 1995 government was thinking to increase the money supply which was brought to 16 percent for that reason inflation rate increased.

In the year 1995 government was thinking to increase the total domestic credit which was brought to 17.6 percent from 4.9 percent (1994). For this reason the inflation rate increased.

In the year 1995 government liberalized Credit to the private sectors in fiscal year 1995 by reducing lending rates including those in the three selected sectors of agriculture, exports, and small and cottage Industries had to be

restrained due to the rise in price levels. For this reason inflation rate has increased.

With a view to ensuring an adequate flow of finance to productive sectors and to boosting economic activity, Bank rate was gradually lowered from 9.8 per cent on 30 June 1990 to 5.5 per cent on 3 March 1994 to control the inflation rate.

On 24 March 1994 Bangladesh accepted the Article VIII obligations of the International Monetary Fund, a commitment to declare its currency convertible for current account transactions and liberalize exchange transactions on current account. Foreign exchange controls, which had constrained transactions for a long time, were lifted for the majority of current account transactions. An interbank foreign exchange market has been established. The exchange rate policy is being managed flexibly so as to avoid appreciation of the real exchange rate and to maintain macroeconomic stability.

Moderate economic growth and modest change in the wage index contributed to the relatively low rate of inflation (i.e., lower than 5 per cent) in 1990-1994.

Higher money supply growth and lower deposit rate in FY95 contributed to the comparatively higher inflation rates in 1995.

In 1996 the lending rate was 13.41 which were accelerated to 14.16 in 1999. Supply shortages in the rural areas originating from political instability in

FY96 and disruption due to floods in 1998 caused serious shortfall of food and also hampered all other agricultural production, which ultimately caused higher inflation rates in 1996, 1998 & 1999.

A lower growth rate, because of lower production and relatively higher depreciation of the exchange rate due to food imports, also contributed to the higher inflation rate in the flood affected years.

Larger depreciation of the exchange rate has accelerated the inflation rate 2.79 (2002) to 4.38 (2004). Exchange rate might have played a significant role in causing inflation in 2005-2006 because of the introduction of flexible exchange rate regime since May 2003.

A higher growth of money supply (13.84 at 2004 to 19.51 at 2006) added a lot to inflation in 2005-2006.

In 2001 the lending rate was 13.75 which were lowered to 10.93 in 2005. In 2001-2006 high inflation in food (more than 5 percent) sector at

international market was so much responsible for the fluctuation of inflation.

Typically import occupies a significant place in the Bangladesh economy, accounting for as high as above 20 percent or more of GDP in FY06. At the margin, most of the essential food items (for example, sugar, rice, wheat, onion and edible oil) and, more generally, machineries, intermediate goods and raw materials used in production are imported. Cost of imports can, therefore, be expected to have a substantial influence on domestic inflation (during 2001-2006) directly (through final goods) or indirectly (through intermediate goods).

Unfair cartel among the suppliers might seriously hamper the course of the economy by engendering inflation via the creation of a false supply shortage even during a period of robust growth in production. Such an undesirable event allegedly occurred in FY06 when the food inflation remained high (7.76 percent) in the same fiscal year despite the growth in food production (4.49 percent8 vis-à-vis 2.21 percent in FY05). Monopolistic control of several food items such as sugar, onion, pulses and edible oil by market syndication seems to have led this situation. Obviously such manipulation is a type of supply side disturbance.

Inflation has emerged as a global phenomenon in recent months largely reflecting the impact of higher food (The IMF food price index was 44.4 percent at June 2008) and fuel prices and strong demand conditions especially in the emerging economies. In line with global trends, Bangladesh also experienced rising inflation with the 12-month average CPI inflation touching 9.94 percent in June 2008.

In the fiscal year 2009, global oil price has shifted upward dramatically so fast. So that the price of fuel & power has driven very sharp impact on our economy by increasing the price of Industrial product and reduces the output of industry. Though our government has taken needed initiatives to minimize the inflation rate but they have failed up to the expectation.

In the fiscal year 2010, global food price has shifted upward dramatically so fast. So that the price of food has driven very sharp impact on our economy. Though the inflation has decreased to a reasonable rate (5.4 percent), the price of food is beyond to the normal people.

Because of the insufficiency of credit to productive sectors it is unable to invest money in productive sectors whereas the money are using in less productive sectors which causes a high rate of inflation.

Recent trends of inflation in Bangladesh Inflation in Bangladesh has been steadily rising in FY10. The easing of

inflationary pressures bottomed out in October 2009 which started softening from previous year. The declining trend in average inflation which started from October 2008 ended in October 2009 and then began to rise in November 2009. This rising trend in inflation was largely because of food prices hike in the domestic markets, incessant rise in international commodity prices including food, fuel and fertilisers due to growing demand caused by global economic recovery, excess liquidity in the internal banking system and higher-than-targeted money supply growth.

The twelve month point to point CPI inflation rose significantly to 8.7 percent in FY10 from 2.3 percent in FY09. The point to point inflation started to decrease in October 2008 and reached the lowest level in June 2009 and then began to rise in July 2009, reached in peak in February 2010.

The annual average inflation followed upward trend whereas point to point inflation showed slightly mixed trend in FY10.

Inflation in Bangladesh is largely driven by food prices. The annual average and point to point food inflation depicted mainly upward trends in FY10. The annual average food inflation surged to 8.5 percent in June 2010 which was 5.1 percent in October 2009 against 7.2 percent in FY09. The point to point food inflation increased significantly to 10.9 percent in FY10 compared to only 0.3 percent in FY09. The average non-food inflation followed mixed trend during FY10 which was 5.5 percent in June 2010 from 5.9 percent in June 2009. On the other hand, the point to point non-food inflation also experienced mixed trend which was 5.2 percent in June 2010 against 5.9 percent in June 2009.

Monthly percentage change in general inflation showed mainly downward trends till November 2009 and then started to rise. Monthly change in general CPI recorded positive figures except negative magnitude in November and April in FY10. Monthly CPI increased by 2.9 percent in July 2009 which was the highest in FY10. Monthly food and non-food Inflation depicted mixed trends.

The food prices were relatively higher in domestic and international markets in FY10. Prices in the international markets have been soaring mainly because of a crop failure in Australia following an invasion of locusts and a wet summer in

Canada. Wheat price already reached a two year high as concerned about a ban on grain exports due to drought in Russia and rotting stock of grain in India. Moreover, there was strong evidence that speculation and wild rumor have distorted prices on the commodity markets which has driven up prices. Rice (coarse) price in the domestic markets stood at Taka 38.6 per kg. or 15.2 percent higher in June 2010 from Taka 33.5 per kg. in June 2009 (Bangladesh Bureau of Statistics).

The Government and Bangladesh Bank adopted some measures to supply timely and adequately agricultural inputs like fertilisers, seeds, pesticides and fuel. The authority planned to provide electricity to rural areas for Boro production in the last season by saving electricity from load-shedding in the urban areas but overall supply was not adequate to fulfill high demand for irrigation.

The Government imposed a ban on rice export in early December 2009. Moreover, the Government provided 'Krishi Card' to 18.2 million farmers for supply inputs like fertilisers, agricultural loans and subsidies on diesel.

Other steps included open market sales of rice in Dhaka city and neighbouring districts for few months in early 2010 and introduced 'Fair Price Cards' for 2.5 million ultrapoor families.

Though petroleum price in the global market has moved over USD 80 a barrel recently, it kept transport cost unaffected in the domestic market due to administered price, resulted in lower non-food inflation.

Bangladesh Bank raised the rates on Cash Reserve Ratio and Statutory Liquidity Ratio from 5.0 percent to 5.5 percent to enchain inflationary pressure and also raised interest rates on Government securities, particularly bonds and started auction of 30-Day Bangladesh Bank Bills as a measure to mop up excess liquidity. Moreover, Bangladesh Bank advised all the commercial banks to cap interest rates at 12.0 percent on import items like edible oil, lentils, pulses, onions, spices and sugar etc. to ensure adequate supply in comparatively lower prices and to keep prices under control.

Rural CPI carries higher weight (70.89 percent) in general CPI compared to urban CPI (29.11 percent). Annual average CPI inflation in the rural areas surged to 7.2 percent in FY10 from 6.8 percent in FY09. The component of food prices increased to 8.0 percent in FY10 from 7.1 percent in FY09, while

the non-food component decreased slightly to 5.6 percent in FY10 from 6.3 percent in FY09.

Annual average CPI inflation in the urban areas rose to 7.7 percent in FY10 from 6.2 percent in FY09. The food component of urban CPI gradually increased to 9.9 percent in FY10 from 7.4 percent in FY09. The non-food component also increased to 5.0 percent in FY10 from 4.8 percent in FY09. Urban consumers experienced a higher rate of 9.9 percent food inflation in FY10, whereas the rate was 8.0 percent for the consumers in rural areas.

Recent Inflation Rate on Graph

Inflation Average

Limitations of Economic systemThe 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.

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 FY09-FY10.

How to control inflation in BangladeshThe inflation of our country is not uncontrollable at all. It may be controlled by the following policy:

1. Offering highly interest bonds: Government can offer high interest bonds to have the money of general people into development work. People also invest money to have some additional interest. Thus money will shift from the peoples to the government. As a result inflation will be stagnated.

2. Declared high interest rate: If Banks offer high interest of the deposited money. People will deposit more money into the banks to have more interest. Thus flow of money can be controlled. As a result inflation will be ill.

3. Issuing profitable IPO in the share market: If some profitable IPO (Initial Public Offerings) be there in the share market, then people will invest money in case of consuming. Thus money flow of the economy can be controlled as well as inflation also be controlled.

4. Inspiring investment: Government can inspire the investor by providing various facilities. Investment will use money in productive sector thus production increase as result inflation will be slowed down.

5. Improving Law & Order situation: Law and order situation has a direct impact in production. In a secure environment production will be increase up. With the increasing production inflation will be decreased.

Needed steps

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.

Bibliography

Books:1. Samuelson, Nordhaus; ‘Economics’; Eighteenth Edition. (McGraw Hill Book

Company).2. Rudiger Dornbusch, Stanley Fischer & Richard Startz; ‘Macroeconomics’; 9th

Edition. (McGraw Hill Book Company, 2011-2012).Web Sites:

1. www. bangladesh-bank.org2. www.bbs.gov.bd3. www.en.wikipedia.org4. www.inflationdata.com