Assignment On

Inflation in Bangladesh Impact, effect, problems & prospect

Development Economics ECO- 3131

Prepared For:
Mehe Zebunnesa Rahman Senior Lecturer School of Business Southeast University

Prepared By:
SK. Shakib Hossain 2007010000082 Reejwan Ahmed 2007070000087 Misbahul Islam 2007010000097 Mahabub Rahman Khan 2007010000079 Ehtesham Uddin Ahmed 2006210000090

15 (c) BBA Submission Date: 23th November, 2008

Letter of Transmittal
November 23, 2008 Mehe Zebunnesa Rahman Senior Lecturer School of Business Southeast University House # 64/3, Road # 18 Banani- 1213 Dhaka, Bangladesh. Subject: Submission of the Assignment. Dear Madam, We would like to submit the assignment which to as done on inflation in Bangladesh. The assignment writing has given us the opportunity to combine our theoretical knowledge with practical experience. We would like to say that if this assignment effect on any organization then well be responsible for that and we dont submit it anywhere. Your valuable advice, suggestion and guidance have helped us to prepare the assignment. We will be very glad, if you kindly accept this assignment. Sincerely yours, Sk. Shakib Hossain

ID: 2007010000082 Reejwan Ahmed ID: 2007010000087 Misbahul Islam ID: 2007010000097 Mahabub Rahman Khan ID: 2007010000079 Ehtesham Uddin Ahmed ID: 2006210000090

ACKNOWLEDGEMENT

First of all we want to thank Allah for making this assignment possible for us. We take the opportunity to thank the vice-chancellor professor Dr. M. Shamsher Ali of Southeast University for giving us an opportunity to work on this assignment. We also extend our sincere gratitude to the head of the department of school of business. It was our pleasure to work under our faculty guide, senior lecturer Mehe Zebunnesa Rahman. We are grateful to her for her able guidance, valuable time, co-operation and inspiration without which the assignment study would not have been completed. Last but not least we express our sincere thank to all our friends and relatives and other people who provide us data and helped us in completing this assignment. Sk. Shakib Hossain

Reejwan Ahmed Md. Misbahul Islam Mahbub Rahman Khan Ehtesham Uddin Ahmed

Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. The term "inflation" once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of moneya loss of purchasing power. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of price inflation is the inflation rate, which is the percentage change in a price index over time. Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. Inflation may widen an income gap between those with fixed incomes and those with variable incomes. High inflation may lead to shortages of goods as consumers begin hoarding them out of concern their prices will increase in the future. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. The consensus view is a sustained period of inflation is caused when money supply increases faster than the growth in productivity in the economy. The task of keeping the rate of inflation low is usually given to monetary authorities who establish monetary policy. Generally today these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

Origins
Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government (e.g. the king or the ruler of the region), melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seignior age. This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced. By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods. This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation).

Inflation Rate
In economics, the inflation rate is a measure of inflation, the rate of increase of a price index (for example, a consumer price index). The rate of decrease in the purchasing power of money is approximately equal. It's used to calculate the real interest rate, as well as real increases in wages, and official measurements of this rate act as input variables to COLA adjustments and Inflation derivatives prices. If P0 is the current average price level and P 1 is the price level a year ago, the rate of inflation during the year might be measured as follows:

Measuring inflation
Widely used price indices for calculating price inflation include the following:

Cost-of-living indices: (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes. Producer price indices: (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put

on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.

Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee. Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Other common measures of inflation are:

GDP deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP). The US Commerce Department publishes a deflator series for US GDP, defined as its nominal GDP measure divided by its real GDP measure Historical inflation before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology Asset price inflation is an undue increase in the prices of real or financial assets, such as stock (equity) and real estate. While there is no widelyaccepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core

inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.

Types of Inflation:
There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model".

Demand-pull inflation: inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion.

Cost-push inflation: also called "supply shock inflation," caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Built-in inflation: induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI aftertax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Characteristics of Inflation
The important characteristics of inflation may be summarized as under: 1. Inflation is always associated with a rise in prices which is continuous and persistent. It is a process of rising prices. It should be distinguished from price rise which may occur temporarily or during a cyclical upswing. 2. Inflation is a dynamic process which can be observed only over a more or lengthy period. 3. Inflation is basically an economic phenomenon; it originates within the economic system and is fostered by interaction of economic forces. 4. Excess of demand over the available supply is the hallmark of inflation. It is a condition economic disequilibrium.
5. Inflation is generally considered a monetary phenomenon for it is

normally characterize by an excessive money supply. All increases in the stock of money may not be inflationary but persistent; rise in prices can not be sustained unless the quantity of money rises as well.

Inflation trends in Bangladesh:

Rising rate of inflation has become a serious concern in Bangladesh in recent years. The impact of rising inflation rate is being felt almost everywhere. The prices of essential commodities have gone up, and so is the cost of living. Countrys vast multitude of poor and unemployed people is having a difficult time to survive. According to the estimates by the BBS, the inflation rate, on a point-to-point basis, in June stood at a 10 year high of 9.20 per cent. The corresponding food inflation rate was 9.82 per cent, and BBS reported that inflation on a point-to-point basis in urban areas was 10.71 per cent. It is feared to go up even further due to floods and Ramadan. According to the Bangladesh Bureau of Statistics (BBS), the overall inflation in Bangladesh was 8.66 percent on 12-month annual average and 11.21 percent on point-to-point basis in November 2007; whereas the food-inflation hit 13.83 percent in the same period. Figure 3 reflects the inflation scenarios in Bangladesh. The trends clearly show that both the 12-month average and the point-to-point inflation are steady since January 2007. Figure 3: Monthly CPI inflation in Bangladesh, December 2006-November 2007 (in percent)

The current level of inflation has surpassed BBs expectations. In its monetary policy statement (issued in July 2007), the BB targeted an annual average CPI within a range of 6.5-7.0 percent. The Economist Intelligence Unit (EIU) has revised its inflation figures forecast upwards for Bangladesh to 8.7 percent in 2008 (from 7.7 percent previously). According to the Consumers Association of Bangladesh (CAB), the prices of different types of rice, flour, edible oil, milk-products, fish, meat, spices, vegetables and energy products have increased notably in Bangladesh from September 2006 to September 2007. Bangladesh has had a history of price volatilities; nevertheless, the level of inflation declined in the economy since 2005 in line with other countries, though it has shown an increasing trend in recent months (Figure 4). Figure 4: CPI Inflation in Bangladesh, 1987-2007

The low and middle group people in Bangladesh are primarily facing the burden of inflation. The exchequer of Bangladesh is also under severe pressure as oil prices are now hovering around US$100 a barrel in the international market. The Bangladesh Petroleum Corporations monthly loss has already exceeded BDT2.50 billion (US$36 million) per month as the state-owned entity sells petroleum products at much lower prices in the domestic market than their

actual import costs. The difference (import price minus local market price) is being absorbed by the government exchequer as subsidies. The losses accumulated in the past have been financed through loans from the state-owned commercial banks.

Causes of inflation in Bangladesh:

Growth of money supply It is often argued by the international lending agencies (i.e., World Bank, IMF and ADB) that inflation is a monetary phenomenon, and it is caused by the excessive supply of money in the economy. Until very recent past, the position of Bangladesh Bank has not been very different from this perspective. While it is true that the broad money growth increased steadily during 2001 and 2007 (with a record growth of 22 per cent in December 2006), along with a rising inflationary rate, the lessening of the broad money growth since Match 2007 did not have any impact as regard to restraining the rising inflationary trend. Guided by the monetarist approach to inflation, the Bangladesh Bank had been following a rather concretionary (cautious in its term) monetary policy, as a result of which the growth rate of domestic credit fell to 14.9 per cent in 200607 as against its growth rate of 20.45 percent in 2005-06. To our opinion, such a concretionary monetary policy has been ineffective in controlling inflation. A tightened monetary policy is unwelcome when the economy has shown signs of near stagflation with slower growth, high inflation and high unemployment. A concretionary policy is likely to have resulted in an adverse impact on investment, employment generation and economic growth for Bangladesh. Very recently, Bangladesh Bank has changed its position, and has announced to move from a concretionary monetary policy to a cautious expansionary monetary policy. We consider this as a pragmatic step. Rising food prices in international market Bangladesh is a net food importing country. As a result, any rise in food prices in the world market push the domestic prices of those commodities to increase. In recent years the prices of essential commodities, like rice, wheat and edible oil have increased significantly in the international market.

The rising world food prices have also serious poverty implications for Bangladesh. Using a dynamic CGE model for Bangladesh we simulated a scenario for a 50 percent increase in the world price of rice, wheat and edible oil. It appears that, under this scenario, the overall consumer price index would rise by 2.3 per cent. This would lead to a rise in head-count poverty by 0.31 percentage point in the rural area and 0.41 percentage points in the urban area. The number of people falling below the poverty line income becomes around 69,500 in the rural area and around 23,000 in the urban area. It appears from the above analysis that rising world prices of food lead to raise the consumer price index with significant margin, and as a result have some profound negative impacts on inflation and poverty in Bangladesh. Simultaneously the issue of food insecurity (or perhaps hunger) will be a matter of greater concern. Rising prosperity Bangladesh has been one of the high growth performing economies over the last 10 years. The GDP base of Bangladesh is not so small that achieving high growth rates would be relatively easy, as in absolute volume terms it represents the 50th largest economy in a sample of 177 countries. Only four countries have grown faster than Bangladesh with bigger GDP volumes during 1996-2005 The proponents of this hypothesis postulate that the high growth rate of GDP and the per capita GDP in particular has led to the creation of excess demand in the economy which resulted in a demand-pull inflation. World Bank, IMF, ADB, and to some extent the government policy makers in Bangladesh, are in favor of this view. However, such views have been questioned by some economists in Bangladesh who consider that high growth rate of GDP should

not create any excess demand in the economy as the growth in GDP will also ensure supply of commodities3 (Osmani, 2007). In our opinion, there are merits in the arguments of both sides. The rise in income (if only equitable) has the natural tendency to exert excessive pressure on demand in the economy. However, such excessive pressure on demand may be met by increased imports, if not by local production. Imports of consumer goods have been experiencing high growth during the last five years. We, therefore, can argue that the rise in per capita income may be one of the factors responsible for creating excess demand situation, but it cant be the major reason for inflation in recent years. However, skewed distribution of the national income does undermine to some extent the case for creating excess demand of goods and services consumed by ordinary people who are our focused group here. Rising fuel prices Bangladesh government increased fuel prices in April 2007. Prices of diesel and Kerosene was increased, on average, by 21 per cent. Arguments have been put Forwarded by the World Bank, IMF, and the ADB that the increase in fuel prices would not have any impact on rising rate of inflation, as diesel and kerosene constitute a very low share in the basket of commodities used for the calculation of the CPIs. However, the rise in fuel prices is likely to have some indirect impacts on the prices of commodities through two major channels. First, the high prices of fuels lead to high cost for irrigation, which raises the cost of agricultural production. Second, high fuel prices increase the cost of transportation, which also raises the prices of essential items transported from remote villages to urban areas. Using the Bangladesh CGE model, we simulated for a scenario of a rise in diesel and kerosene prices in Bangladesh by 21 per cent (as executed in April 2007), and it appears that such a rise in the fuel prices increases the consumer price index by 1.1 per cent. Fuel price rise also has some poverty implications, as this would lead to an increase in head-count poverty by 0.11 percentage point in rural and 0.19 percentage points in urban areas. Under this scenario around 25,000 rural and 11,000 urban households fell into poverty. Therefore the increase in the prices of diesel and kerosene in April 2007 has contributed to the rising trend of inflation in Bangladesh.

Depreciation of Bangladeshi Taka

Since 2002 Bangladeshi taka has depreciated much against US dollar while Indian rupee has been appreciating. This has resulted in a major depreciation of Bangladeshi taka against Indian rupee. India is one of the major sources of Bangladeshs imports, as imports from India in recent years constitute more than 20 per cent of Bangladeshs total imports comprised of many essential food items. As a result, import cost for Bangladesh has gone up. Figure 5: Nominal exchange rate for Taka and Indian Rupee against US dollar (left) and Taka-Rupee real exchange rate (right)

This depreciation of Taka hypothesis seems to provide a reasonably plausible explanation to the rising prices of essential food items in Bangladesh. However, There are some disagreements among the economists and policymakers with regard to combating this situation. It has been argued that Bangladesh Banks policy of foreign reserve accumulation is not consistent with the continuing deprecation of taka in recent years. Therefore, releasing some dollar from the foreign reserve to the domestic market is suggested with a view to restrain the excess demand for dollar (e.g., Osmani 2007). However, such arguments have not been endorsed by the Governor of Bangladesh Bank. In his view, the current amount of foreign reserve is not an optimal one, and there is a danger of depleting the foreign reserve for a country like Bangladesh. Non-competitive market (Syndicate) The syndicate hypothesis argues that many middle-men, wholesalers and importers are acting as syndicates and are causing huge price hikes, by making cartels and hoarding essential goods like rice, wheat and edible oil. These cartels fix the prices of these goods, dictate supply in the market, and earn excess profits. This hypothesis has become one of the dominant hypotheses in explaining inflation in Bangladesh. There are, however, a number of counter-arguments of this hypothesis. First, it is argued that there is no concrete evidence of the existence of syndicates in the markets of essential commodities. Second, though there are imperfections in the market, and as a result consumers are paying higher prices than the perfectly competitive prices, this phenomenon cannot explain the accelerating inflation. In general, imperfect market is likely to affect the level of price, but in order to have effective influence over accelerated price rise, the market concentration must also increase at an increasing rate, which is argued to be non-existent. In our opinion, though there are no concrete evidences of established syndicates in the markets of essential commodities, taking advantage of the weak consumer protection laws, there might be some short-term alliances among the suppliers of these goods to influence over supply and prices. This may have some impact on the rising prices of essential items.

Anti-corruption drive and disruption of supply chain

It is thought that due to the recent anti-corruption drive many businessmen have contracted their usual business activities with the fear of legal actions. Furthermore, any informal marketplaces, both in rural and urban areas, have been wiped out by law forcing agencies on legal grounds. Such actions have resulted in a disruption in he established supply chains, which certainly have exacerbated the inflationary rend. In our opinion, regaining the confidence of the businessmen in their usual business activities is very important for the smooth functioning of the supply chain. This is very important, not only to curb inflationary pressure, but also to get rid of the current state of stagnation in the economy. Slow growth in agriculture There is a declining trend of growth in agriculture over time, especially of the crop sector in Bangladesh. This has resulted in less domestic production relative to the domestic demand.

Slower growth in agriculture, and especially of the crop sector, is due to a number of factors:
1. failures in timely supply of fertilizers, seed and pesticide to the farmers.

2. increased cost of irrigation because of rise in diesel price as about 70 per cent irrigation pumps are run by diesel; 3. decline in the availability of cultivable land because of population growth and rehabilitation; 4. change in pattern of crop production, as there are increasing tendencies to switch over to the cultivation of exportable crops that are more profitable; 5. Wastage of about 30 per cent vegetables because of shortage of cold storage. Severe flood during July-August 2007 has also exacerbated the situation. To our opinion, slow growth in agriculture, and especially in food production, is one of the major causes of accelerated inflation in Bangladesh in recent years Growth of remittances Bangladesh has been experiencing a steady rise in remittance inflow over the last few years. In 2006-07, the growth of remittances was 24.49 per cent. There are arguments that such inflow has also contributed to demand-pull inflation in Bangladesh. Though there are some merits in this argument such as the Rising Prosperity Hypothesis, increased remittance inflow is unlikely to be a major cause of inflation, as the rise in demand has been supported by the rise in supply through increased imports. Labor Cost Wage, the labor cost, is often seen as the key reason behind cost-push inflation. Wage increase without any commensurate increase in productivity kicks off a wage-price spiral, allowing for sustained inflation. Analysis of the movements of nominal wage rate inflation generally gives an idea about the labor cost scenario. The time path of the nominal wage inflation portrayed in Figure-2 suggests that in Bangladesh, the wage inflation has been pretty stable at above 5 percent per annum with some short-term fluctuations over the period from July

03 to June 06. Under the assumption of little or no improvement of workers productivity growth, wage inflation at such high level is an indication of cost escalation over time. However, whether the accelerated cost has translated into inflation is not clearly observable in the figure. An analysis of the correlation matrix presented in Box-1 is useful in exploring the precise link between labor cost and inflation. It is seen from the matrix that wage rate inflation has statistically significant association only with rural food inflation (coefficient of 0.22) at the 10-percent level of significance during the period from FY00 to FY06. It, therefore, appears that wage inflation cannot be a dominant factor in explaining the price behavior in Bangladesh. This is what one would normally expect in a labor surplus environment. Supply Shortage Production in agriculture and fisheries sectors in Bangladesh is still subject to the whims of nature to a notable extent. It has been claimed that one of the main causes of the high food inflation throughout the FY05 was poor harvest of aus, aman and wheat crops. the yearly production of these three crops went down by 18.12, 14.76 and 22.11 percent respectively in FY05 over the FY04. Import Cost 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 directly (through final goods) or indirectly (through intermediate goods). According to available statistics, import price index (MPI) of Bangladesh has continuously soared over time which is reflected by an almost straight upward curve in Figure-3: Import Cost and Inflation (12-month moving average)

Figure-3. The figure also depicts the inflation trend. Comparison among the trends in import price index and inflation provides an observation about the relationship between these indices. It is seen that although during the period from FY97 to FY01 the relationship is somewhat ambiguous, the co-movement from FY01 onward appears robust. To verify this relationship, a separate correlation matrix has been constructed using yearly data for the period from FY01 to FY06.3 The correlation analysis, presented in the Box-2, reveals that while the relationships between import price index and categories of non-food inflation (urban and rural) are insignificant, the former is found to have economically as well as statistically highly significant association with the categories of food inflation (urban and rural). The positive association is suggestive of the hypothesis that the surge in inflation is in part a supply side phenomenon. Evidently, the reasons for increase in import price are twofold- exchange rate depreciation and increase in international commodity prices.

Impact of Inflation
One obvious consequence of inflation is the erosion of real income of the people resulting from the general increase in prices. The burden of income loss, however, differs across different income groups. No doubt, the household groups who are employed in the formal sector and whose salaries/wages are fixed in nominal terms and are re-fixed periodically are the worst sufferers. The same is true for those employees in the informal sector who have income fixed in nominal terms. In Bangladesh, a major concern, however, is the inflationinduced loss of real income of the poor. While assessing the impact of inflation on the Poors income, it is important to keep in view that the poor is not a homogeneous group and they derive income from a variety of sources. The livelihood activities of the poor are diverse and their sources of household income are multiple, often involving subsistence and home-based production and participation in the low-remunerative activities in both formal and informal economy.4 The Household Income and Expenditure Survey (HIES) 2005 shows that, in the rural areas, the poor mostly consist of wage-labor based workers in agriculture and other no farm sectors, and other

low-paid workers in production, services, and other activities. In the urban areas, the profile of the poor is very similar with daily wage laborers forming the majority. This shows that, since labor is the only major asset of the poor, the return to labor is the major source of their income. The evidence on income adjustment thus indicates that the poor day laborers in Bangladesh have some ability to at least partially revise their nominal wage income in a quick manner to compensate for the loss in real income due to inflation. This shows that nearly half of the poor in the rural areas and more than one-third in the urban areas can negotiate an upward adjustment in their major source of earning, the wage component of household income, in the face of inflation and therefore can somewhat protect themselves against the onslaught of inflation although the net welfare impact could go either way since they would probably receive higher prices for some of the commodities that they sale (e.g. household production items) while they would pay higher prices for many of their purchased goods. On the other hand, most of the components of income and expenditure of the poor households belonging to the selfemployed category, who constitute more than one-third of the poor households in both rural and urban areas, are affected in diverse ways so that the net impact of inflation is difficult to predict a priori. The welfare of the salaried poor households, though constitute only around 5 percent of the rural poor households but around a fifth of urban poor households, are more likely to be negatively affected since their real income is eroded by rising inflation while they pay higher prices for purchased goods. The remaining major poor group comprising nearly 10 percent of the poor households in both rural and urban areas belongs to unemployed/not working category households and these households no doubt become extremely disadvantaged with rising inflation.

Inflation and Economic Growth Nexus

The nexus between inflation and economic growth remains a controversial one in economic literature as both the monetarist and the structuralists have different opinion on the role of inflation on economic growth. The monetarists view inflation is detrimental for economic growth whereas the structuralists opine that it is essential for growth. Bruno and Easterlys (1998) study supports the views expressed in Dornbusch and Reynoso (1989), and Levine and Renelt (1992) on inflation-growth nexus. Their investigation reports a robust empirical result that economic growth falls

sharply during high-inflation regimes. Using data for around 100 countries from 1960 to 1990, Barro (1995) found that an increase in average inflation by 10 percentage points per year reduces the growth rate of real Gross Domestic Product (GDP) per capita by 0.2 to 0.3 percentage points per year and the ratio of investment to GDP falls 0.4 to 0.5 percentage points. His study also shows that although the adverse impact of inflation on growth sounds small, the long run effects on standards of living are substantial. Following a seminal work by Stanley Fischer (1993), there is a broader consensus amongst researchers that extreme inflation rates (for instance, above 40 percent per year), are associated with reduced economic growth. Using nonlinear estimation techniques, Khan and Senhadji (2001) has found a negative relationship between inflation and growth. Their paper shows that above a threshold level (one percent to three percent for industrial economies and 11 percent to 12 percent for developing economies) inflation considerably slows growth. Ahmed and Mortaza (2005) shows there exists a statistically significant longrun negative relationship between inflation and economic growth in Bangladesh. Their model found that for Bangladesh six percent is the threshold level (that is, structural break point) of inflation. The paper concludes that any rate beyond this adversely affects economic growth in Bangladesh. In short, it can be said with some reservations that a low to-moderate-inflationary regime is a sine qua non for the pursuit of economic growth with stability. Expenditure pattern and inflationary implications The distribution pattern of consumption expenditure for food and nonfood items in rural and urban areas in 2005 shows the overwhelming dominance of food items. The average share of food items is 58.6 percent in rural areas; while the share is 45.2 percent in urban areas.3 These shares of food items, moreover, remain at high levels across different decile groups; declining slowly from 68.3 percent for the bottom 5 percent to 61.7 percent for the 8th decile in rural areas; and from 66.7 percent for the bottom 5 percent to 51.0 percent for the 7th decile in urban areas. Moreover, the share of cereals (mostly rice) in total food expenditure is high; 42.3 percent in rural areas and 31.3 percent in urban areas. The above shows that, although current trend shows lower food inflation in the rural areas compared with the same in the urban areas, the impact of food price inflation on the rural people could be significant in view of the high weights of food items in their consumption basket. Moreover, the burden increases for the

lower income groups as these groups spend a larger share of their budget on food. Benefit of increasing food prices: The welfare gain (or loss) of different income groups, especially the producers of food crops, resulting from increasing food prices is a contentious issue in Bangladesh. The majority of the farmers in the country are rice producers and their welfare, no doubt, is significantly determined by returns to rice production. Moreover, the variability of returns from crop production is high, especially in the aus and aman seasons, mainly due to frequent incidence of floods and other natural disasters (such as two consecutive floods in July-September 2007 and the cyclone in November 2007). Similarly, production in the boro season critically depends on timely and uninterrupted availability of required quantity of fertilizer, diesel, electricity, high quality seeds, agricultural credit, and other inputs by the farmers. In this context, it is also important to highlight that the overwhelming majority of the farmers in Bangladesh belong to small and marginal category who own and operate small pieces of land. In 2005, about 90.5 percent of the rural households had owned land of less than 2.5 acres; while 72.9 percent had less than 1.0 acre. The distribution of operated land is also very similar: 90.3 percent operate less than 2.5 acres and the operated land for 71.2 percent is less than 1.0 acre. This shows that the vast majority of the crop producers in Bangladesh, including the rice producers, are small and marginal farmers and they mostly constitute net purchasers of food items, especially rice. In recent years, prices of food commodities, especially that of rice, have been increasing in the country. The average retail price of fine quality rice in Dhaka city rose by 41 percent in December 2007 over its average value in FY07; while the increase in the case of coarse rice over the same period was by 33 percent. The prices of other essential food commodities experienced similar increases. In the rural areas, retail prices of rice and other major food commodities have also shown similar trends. The average price of rice at the producers level, however, increased at a slower rate; by less than 12 percent between January 2005 and July 2007, with little fluctuations around the modestly rising trend. On the other hand, producers prices of other major agricultural commodities, especially seasonal products and vegetables, showed increasing but more fluctuating price movements.

The increase in the market price of rice is likely to have different implications on various population groups in the country. An analysis of the value chain of domestically produced rice in Bangladesh shows that, on average, around 44 percent of the unit price paid by the consumers is attributed to production and processing costs, 19 percent goes as margin to the producers, nearly 24 percent is appropriated by the millers and wholesalers, 12 percent goes to the retailers, and less than 1 percent goes to local traders. In the case of imported rice, import cost accounts for 85 percent, while 5 percent is retained as margin by the importers, and less than 10 percent goes as wholesale and retail margins

The above shows that, on average, less than a fifth of the price paid by the consumers accrues to the domestic rice farmers as margin. The important point, however, is that the above margin goes to the producers only on the price at which they actually transact in the market. Since the vast majority of the rice producers in the country belong to small and marginal farmer groups, most of them have little, if any, marketable surplus. Moreover, they usually sell the surplus immediately after the harvest to meet other pressing needs; and even if they do not have any surplus, they usually sell a part of their production to meet such demands and purchase rice later on presumably at higher prices. This shows that the benefit of higher rice prices can accrue to the majority of the rice farmers only if rice prices are high in the harvesting seasons; while any subsequent increase in rice prices in the retail market mostly benefits the millers, wholesalers, and the retailers.

In this context, it is also important to note that, since more than 90 percent of the farmers including the rice cultivators, belong to the small and marginal category; the vast majority of the rural people including the landless rural laborers and other disadvantaged groups are net purchasers of rice in the country. In the urban areas, the share of households who belong to the net purchasers of rice category and is dependent on the market is likely to be higher. The above shows that any price increase of domestically produced rice could bring benefit to the majority of the rice growers through providing a share of higher prices to them only when reasonable and competitive rice prices are maintained after harvest. The gain resulting from any subsequent rise in rice prices in the retail market largely accrues to the millers, stock holders, other dealers, and probably a few large rice producers without much benefit to the majority of the small rice producers who form the overwhelming majority. In the case of imported rice, the margin from higher retail prices is shared between the importers and the wholesalers and retailers. On the other hand, since the vast majority of the populations in both rural and urban areas are net purchasers of rice, this large group especially the poor faces significant disadvantages and real income erosion when rice price increases. The increase in prices of most other domestically produced food crops, especially vegetables, has strong seasonal dimensions. The prices of these commodities usually show wide fluctuations depending on market availability and temporary shortages and disruptions in the supply chain. While the major share of higher prices in the retail market is normally appropriated by the intermediaries, a small share probably percolates down to the producers facilitated by imperfect adjustments in producers prices in line with retail price changes. The producers, even the small ones, are able to derive the benefit mainly due to the practice of harvesting and selling in small lots over a period. The major impediment, however, is the weak market (including lengthy and often imperfect supply and transport networks) and its disjointed chain that create supply-demand mismatch at the local level leading to gluts in supply especially in the peak season and distress sells and wastages (this is especially true for bulk, low value, and perishable products) in the absence of preserving and processing facilities.

Bangladesh Banks Credit and Exchange Rate Policies and Inflation

Inflation is always and everywhere a monetary phenomenon said by Nobel Prize winning economist Milton Friedman whose views are anchored in the quantity theory of money (M.V=P.Q, that is, excessive money creation spawns inflation). Economists by and large hold this view. The relative prices in an economy arise from productivity and competition (real factors) and quantity of money in circulation (absolute factor). In the long run, Friedmans theory prevails, however, in the short-run the relationship between money and inflation can be less obvious. In this section, we will discuss the role of credit and exchanges rate in checking inflation where the BB has a big role to play. Contrary to the Bangladesh Banks cautious, restrained monetary policies, both broad money and credit aggregates expanded substantially in 2007. According to the BB, M3 recorded an increase due to higher than envisaged growth in net foreign assets (due to increase in workers remittances and export earnings). Figure 8 shows both M3 and credit growth in the economy has been steady in 2007. Figure 8: Broad Money (M3) and Credit Growth, December 2006- November 2007 (Taka in Crore)

As economies have been globalizing steadily in recent decades, the role of exchange rate has become a critical factor in determining inter alia a countrys competitiveness as traditional tools like tariff and quotas have become less effective, if not obsolete, to manage trade and finance. It also an important channels to keep an economys major macro variables (such as balance of payment, inflation level, etc.,) in order. The case of the alleged undervaluation of the Chinese Yuan vis--vis the USD and the Euro is a classic example in this regard. Bangladesh adopted market-based floating exchange rate system from May 2003 abandoning the two-decade long BDT-USD peg. Although, the direct intervention in the foreign exchange market under the floating exchange rate regime is limited, at least theoretically. However, like many central banks, the BB does intervene in the market. Since 2003, the BDT has depreciated around 16-18 percent against the USD (Figure 9). In 2007, the BDT witnessed a modest appreciation against the USD (Figure 10). At the same time, the USD has seen a sharp depreciation against major currencies which is known as the USD index.11 Further, apart from basket of foreign currencies, the USD depreciated sharply against the Indian Rupee, the Thai Bhat, the Singapore dollar, and the Australian dollar, among others, who are Bangladeshs major trading partners.

Moreover, as can be seen in Figure 12, the BDT depreciated vis--vis its trading partners currencies. From October 2006 to November 2007, the value of the BDT did fall sharply against the Euro, the Indian Rupee, the pound sterling, the Thai bath, the Australian dollar, the Swedish Crone, the Singapore dollar, the Japanese yen and the Chinese Yuan, among others. In the same period, the BDT appreciated modestly against the USD and some other currencies that are pegged with the USD (the Kuwaiti diner, the Hong Kong dollar and the Taiwanese dollar). As a result, the NEER index has been downward slopping in the corresponding period. Figures 13 and 14 also show that the NEER index is not only downward during 2006-2007, rather it also followed the same pattern (downward trend) before the said period, as the BDT experienced continual depreciations against its major trading partners currencies in recent years. In Figure 11, we can see that the CPI inflation in Bangladesh is higher than almost all of its trading partners domestic inflation. Consequently, the nominal depreciation of BDT has been offset by high level of inflation in Bangladesh compared to its trading partners which is reflected in upward trend of REER (Figures 13 and 14). One of the important findings of the open-economy macro literature is that NEER and REER move quite closely together, except in high inflationary environments. For example, the movement of NEER and REER of the Based on the above facts, apparently the BDT is undervalued and cost of maintaining an undervalued exchange rate can be self-defeating. Economic theories show that if the nominal exchange rate does not allow sufficient appreciation, real exchange rate adjustment only happen through increase in the price level over time, relative to trading partners. In Figure 14, we can see that the REER index had been in declining trend since 1998 and it had maintained the same pattern till 2006. However, since 2006 the REER index has shown as upward trend. The behavior of the REER index in the said period indicates that the Bangladesh economy got some benefits from its undervalued currency for a decade, however, the ongoing high inflation regime has chocked out those advantages in recent months. When it comes to currency revaluation, the BBs dilemma is understandable. An undervalued exchange rate favors the countrys exports and encourages overseas Bangladeshis to send remittances.

Consequently, the BB is reluctant to allow the BDT appreciating significantly against the USD and Bangladeshs other trading partners currencies. However, it should be remembered that an undervalued currency also taxes consumption of tradable at home. The importers pass-through the excess domestic currency they pay for the import payments to the consumers. Consequently, the prices of tradable soar in the domestic markets. Further, it discourages people to save their surplus income, as high inflation erodes nominal interest rate gains. For instance, in Bangladesh currently the deposit rate on savings account is around 7 percent which is lower than the economys current inflation rate. On the other hand, currency appreciation makes the export sector uncompetitive and encourages consumption. In recent years, the export sector of Bangladesh has expanded considerably thanks to the boom in the apparel sector. Moreover, the growth of remittance flows in the country has been phenomenal since 2000. While the import growth has been moderate in the same period. These positive developments in the external sector have helped the BB to maintain a healthy foreign exchange reserves. The countrys reserves accumulated to US$6 billion as at March 2008. It is worthwhile to note that many East Asian economies created wealth at their early stages of development inter alia keeping their exchange rates undervalued12 (also known as mercantilism). Nevertheless, the East Asian economies gradually sought competitiveness through some other vehicles, such as institutional reforms and productivity gain. Moreover, to maintain the advantage of a competitive (undervalued) currency, central banks need supports from fiscal authorities. As Rodrik (2007) opined: maintaining a competitive currency requires a rise in domestic saving relative to investment, or a reduction in national expenditure relative to income. Otherwise, the competitiveness gains would be offset by rising inflation. This means that the fiscal authorities have a big responsibility: to target a structural fiscal surplus that is high enough to generate the space needed for real exchange rate depreciation. Clearly, in Bangladesh the fiscal sector is also not in the comfort zone. According to the ADB, the fiscal deficit is projected at 4.2 percent of GDP for the fiscal year 2008, compared with 3.2 percent in the preceding year. In its latest projections, the ADB believed that the pressures on the fiscal balance are likely to be amplified because of a rise in expenditures for the relief effort, expansion of food-assisted safety nets, and imports of food grains and fertilizer.

Controlling inflation:
Monetary Policy Monetary policy is the most effective and widely used instruments to control inflation. This policy is operated by Bangladesh Bank. They use different types of instruments. These are given below: Bank Rate Policy The bank rate or discount rate is the rate at which central bank give loan or makes available financial accommodation to commercial banks by discounting government or other first class approved securities offered by the commercial banks. At the time of inflation Bangladesh Bank will raise bank rate which will discourage the banks to take loans from the central bank. This will tend to reduce their liquidity and also induce them to raise their interest rate. Thus this will reduce the availability of credit and also raise its cost. So money supply will be controlled. Open Market Operation Open Market Operation refers to the buying and selling of government and other approved securities by the central bank in order to withdraw liquid funds from the banking system or inject the same into that system. At the time of inflation central bank sells securities to the banks and general public at exciting price. So the public become encourage buying these securities. This action will reduce the reserves of the banks and liquid funds of the general public. Therefore public will withdraw their deposits from banks so that banks reserve will decrease and will not be able to supply credit. Reserve ratio changing policy ( CSR, SLR) Bank by bank credit ceiling Interest rate ceiling Directed credit Moral persuasion Direct action

Fiscal Policy Fiscal policy is budgetary policy in relation to taxation, public borrowing, and public expenditure. Changes in the total expenditure can be effected by fiscal measures. To combat inflation, fiscal measures would involve increase in taxation and decrease in government spending. During inflation the government is supposed to counteract an increase in private spending. Obviously, during a period of full employment inflation, the aggregate demand in relation to the limited supply of goods and services is reduced to the extent that government expenditures are curtailed. A curtain public expenditure along is not sufficient. Government must simultaneously increase taxes to affect a cut in private expenditure also, - in order to minimize inflationary pressures. As we know, when more taxes are imposed, the size of the disposable income diminishes, as also the magnitude of the inflationary gap, given the available supply of goods and services. Inflationary pressure is significantly weakened by the simultaneous curtailment of government expenditure and an increase in taxation because, more resources are released for expanding the productive capacity in the private sector; the supply curve of aggregate goods and services shifts upward with a contraction of monetary demand due to a decline in disposable income with people. Briefly, fiscal policy alone may not be very effective. An effective program for combating inflation should combine fiscal and monetary tools in a manner complementary to one another. Direct Controls Direct controls refer to the regulatory measures undertaken to convert an open inflation into a repressed one. Such regulatory measures involve the use of direct control on prices and rationing of scarce goods. The function of price control is a fix a legal ceiling, beyond which prices of particular goods may not increase. When ceiling prices are fixed and enforced, it means prices are not allowed to rise further and so, inflation is suppressed. Under price control, producers cannot raise the price beyond a prevailing level, even though there may be a pressure of excessive demand forcing it up. Wartime price control is an example of such attempts to suppress inflation.

Direct Controls have the Following Advantages:

1. They can be introduced or changed quickly and easily; hence, the effects

of these changes can be rapid. 2. Direct controls can be more discriminatory than monetary and fiscal controls. 3. There can be variation in the intensity of the operation of controls, from rime to time, in different sectors. 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. Declared high interest rate: If Banks offer high interest on 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. 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 control as well as inflation also be controlled. 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. 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.

Conclusions and Policy Notes

The global demand for commodities fluctuates in line with the business cycle, however, the disproportionate demand for fuel and non-fuel commodities generated by emerging markets might change the age-old trend of long-term commodity price indices (flat-shape of the curve) considering the fact that two emerging markets (China and India) alone make up almost two-fifths of worlds population. So, huge appetite for commodities could keep this upward trend of commodity indices in the near future. Further, climate change might change the global food production map substantially where Bangladesh is predictably the net loser, as climate change poses severe risk to the countrys agriculture production. Consequently, Bangladesh needs to adopt both longterm and short-term strategies to cope with the global commodity boom. In the long-run, Bangladesh needs to develop multi-prone strategies to increase food production taking its food grain demand growth and climate change issues into account. Long-term policies are beyond the scope of this paper. Some medium to short-run strategies are suggested below: First, coupled with higher commodity prices in the international markets, the supply-side constraints in the commodity markets in Bangladesh have further instigated the price hike. As discussed, the market mechanism in Bangladesh is highly distorted. As a result, there is a broad divergence between domestic and international market prices (as well as rural and urban market prices) of commodities. The World Banks doing business statistics show that out of 178 countries Bangladesh ranked 92nd in terms of ease of doing business. It takes 74 days to start a business in Bangladesh.13 The current government has made some progress in terms of reforms in some key areas of the economy; however, the country badly needs drastic institutional reforms to free the market from distortions. Secondly, the role of the BB is critical in containing inflation in Bangladesh, as its credit, interest rate and exchange rate policies are crucial to check inflation. Apparently, the BDT is substantially undervalued and the country is buying inflation from abroad. Here is the huge policy dilemma for the central bank of Bangladesh. In an economy like Bangladesh where institutional bottlenecks and market failure are prevalent, currency undervaluation acts as a second best mechanism for alleviating these two drawbacks (for details see, Rodrik, 2007). As a result, a large appreciation of the BDT might not be a feasible option at this stage as such a move might disrupt the countrys export sector and labor

market. While the undervalued currency is necessary in the short-run, nevertheless, the countrys exporters shall not solely depend on undervalued exchange rate as a means of competitiveness in the long-run. Further, as discussed earlier, to maintain the advantages of its undervalued currency, there is a need for co-ordination between the central bank of Bangladesh and the countrys fiscal authorities. Nevertheless, the BB should allow modest appreciation of the BDT so that it plays at least a small part in mitigating the currency-induced inflation. The BB should also use its key policy rates prudently so that the market does not have excess liquidities. The rehabilitation programs followed by floods and cyclone Sidor are likely to exacerbate credit growth. The BB should adopt restraint monetary policies to control money supply. The monetary policy should be formulated carefully so that there is a reasonably stable linkage between interest rate, money supply and prices. Thirdly, the concerned authorities should take prudent decisions on petroleum subsidies. It is understandable that the direct pass-through of the oil prices at this stage poses high political risk, as the economy is already experiencing skyrocketing inflation. Nevertheless, financing the fiscal deficits through borrowing is in fact passing through the present fiscal burden to the generations to come which is not acceptable, at least ethically. The economy should economies the fuel costs. People should pay for the high-end energy products according to the usage. Instead of subsidizing all kinds of consumers, it can increase the price of oil and other high-end energy products gradually. However, it should continue to absorb substantial, if not full, the price hike of poor peoples energy such as kerosene. Last but not least, the current inflation in Bangladesh could not be explained solely on the economic numbers and graphs as some non-economic factors (drive against corruption, market distortions, low business confidence, political uncertainties, etc.,) have also contributed to the price hike. So, the concerned authorities should take into account all these factors when they formulate policies to check inflation. To maintain price stability, the government must work on both economic and non-economic factors that have instigated the ongoing inflation.