Monetary policy

The objective of this term paper is to bridge the gap between textbook knowledge and real life situation. I have tried to focus about the central bank independence in the world and in Bangladesh. With great enthusiasm and interest I prepared this term paper and while preparing I gathered valuable experiences. The main objectives of this term paper are as follows: ? Central bank autonomy around the world ? Importance of full autonomy in the developing country ?

Central Bank Independence in Bangladesh ? Conclusion and Recommendations Scope This paper focuses on a broad-spectrum talk on the real life scenario of central bank independence in the world and in Bangladesh. A tough effort had been placed while the term paper was prepared and a careful study was made to analyze the information from different report and ultimate findings of the paper. Overall, this term paper is an effort to route for a better understanding for the learners of banking student.

Limitations While preparing this term paper, I have faced some problems. The main problem was time constraint. Because I have to remain busy with my own job. Moreover, during data collection I faced several problems. There is a little scope to use paper based data and statistical tools, rather the report is focused on real life analysis. I have collected this data from different report, websites and internal information of banks etc.

Framework of the Report I have analyzed the scenario of independence of central bank in Bangladesh and all over the world. I have included the administrative and functional autonomy of central bank in Bangladesh. Introduction: The issue of central bank independence has rapidly become the worldwide model for the organizations of monetary authorities aiming at to decrease inflation by increasing the credibility of commitments to price stability.

Independent central banks, it is argued, offset unwanted output variability originated from political uncertainty and may also lead to an elimination of the inflation bias either through an optimal contract or inflation targeting mechanism, or through a reputation-building effect. However, an inflation targeting arrangement that gives instrument independence and goal independence to the central bank reduces the inflationary bias of monetary policy making.

The reason for this is that if the inflation target is publicly announced, the arrangement is transparent, solves the private information problem and makes reputation more effective. It is also argued that central bank independence is the institutional solution to check the macro-economic populism i. e. , opportunistic political business cycles (elected politicians have incentives to expand the money supply prior to elections to stimulate the economy and thereby engineer their re-election).

However, the relationship between central bank independence and effectiveness of monetary policy can be viewed from three distinct paradigms, a) under central bank independence, it is expected that the dynamic inconsistency problem of optimal monetary policy will be solved, b) in case of conflicting objectives of economic policy, inflationary bias of the economy will be minimized, and c) an independent central bank will be emerged as a credible institutional alternative to a constitutionally stipulated monetary rule. Central bank autonomy around the world

Central bank all over the world enjoys various notch of autonomy. In some countries the central bank has more power to both administrative and operational autonomy. However some country’s central banks power is fully restricted to formulate or implement the monetary and fiscal policy or to perform other functions that a central bank generally conducts. Beside this two extreme position some central banks enjoy partial or mixed type of autonomy. Importance of full autonomy in the developing country Central bank plays a vital role in the economic development by formulating and Implementing monetary policy.

In developed country there is a traditional concept of a central bank confining its role to the traditional function. In such economies the central bank confines its role to the standard duties such as exchange rate stability, external liquidity maintenance and care of a balanced relationship between credit demands and credit availability. However in the developing country for their political commitment most of the time the party in power, tries to achieve short-term development through controlling over central bank’s monetary and credit policies.

Further financial institutions in these countries are often weekly established or too closely related to the government by either personal ties or, dependence on government favor . These countries also have the, problems of currency substitution, uneducated and unskilled manpower etc. In this immature financial system private and foreign financial institutions try to dominate over national and international transactions and want to avoid or influence over the, central bank policies.

Further central bank in developing countries is often susceptible to political persuasion. Under these circumstances it is very difficult and often impossible to perform the true functions of a central bank and manage inflation through an effective monetary policy. Central bank autonomy and inflation are negatively correlated. Monetary policy produces higher than desirable inflation level when run by government. The argument is that the outcome could be prevented in one of two ways.

The policy makers can make a commitment not to influence, or monetary policy can be removed from the hands of politicians and given to a body with no incentive to carry favor with electorate (i. e. to an independent central bank). Other experts like also found that the independent central bank delivered lower inflation than did dependent bankers. Hence the more independent central banks are better at stabilization than less efficient banks, because their fiscal policy is more disciplined in countries with more central bank independence.

Therefore, independent central bank can secure the interest of the country and achieve the economic development perfectly through formulating and implementing monetary and fiscal policy independently. However, such a wide range of functional responsibility may only be able to manage when the bank perform within highly integrated economics with matured financial system and educated and well-informed populations. Thus the central bank in developing countries must be led by the objectives given by the needs to bring about changes in the economic structure of the country for obtaining a better economic stability.

Central Bank Independence in Bangladesh Bangladesh Bank was established under the supervision of the Ministry of Finance after independence of Bangladesh with the Bangladesh Bank Order, 1972 to control the monetary and credit system of Bangladesh. The key objectives of the bank was to stabilizing domestic monetary value and maintaining a competitive external per value of Bangladesh taka towards fostering growth and development of the country’s productive resources in the best national interest.

The bank’s functions as mentioned in the Bangladesh Bank Order 1972 and the Bangladesh Bank (Amendment) Act 2003 are: to formulate and implement monetary policy and to formulate and implement intervention policies in the foreign exchange markets; give advice to the government on the interaction of monetary policy with fiscal and exchange rate policy; hold and manage the official foreign reserve of Bangladesh to promote, regulate and ensure a secure and efficient payment system, including the issue of bank notes. Bangladesh Bank also regulates and supervises other banking companies and financial institutions in the country.

However recently there are lots of debates on ‘the full autonomy of Bangladesh Bank’. This autonomy mainly means both the administrative and operational autonomy. Administrative autonomy In case of administrative autonomy Bangladesh Bank does not enjoy full autonomy. To function independently a central bank needs independent board of directors or management who will act independently with greater power to establish and maintain monetary policy for the economic development of the country, not for the interest of the party in power.

According to the Article 9(3) of the Bangladesh Bank Order, 1972 (Amendment 2003) the board will consist of a Governor, a Deputy Governor, and seven Directors. Among these seven directors three will be government officials and nominated by the government of the Republic. The other four members are not government officials however nominated by the government. The Governor, as the chief executive officer of Bangladesh Bank, shall be appointed for four years by the government on such terms and conditions the government may determine.

The Governor can be removed if party in power thinks in any reason that the Governor is incapable to perform his duties. Thus the appointment and also the removal of the bank Governor solely depend on interest and mode of party in power i. e. , the government. The general trend of the country’s government is always to nominate a person as Governor who, they think, can perform the best of their (government) interest. Hence to be in his chair, the governor always would try to keep his office safe by showing either direct or indirect accountability to the government.

One former governor of Bangladesh Bank expressed his view in this regard as, Bangladesh Bank Full Autonomy – Too Early or Too Late “Bangladesh Bank is not a statutory organization but need to be such where government will not be able to remove governor or deputy governor before the end of the term”. In the history of Bangladesh no governor was able to continue his office for full period except one. Moreover, government will be succeeding to influence the other members of the board for the same reasons. This practice, therefore, imposes constraints on the true autonomy of Bangladesh Bank.

Functional Autonomy In case of functional or operational autonomy, Bangladesh Bank also has a limited power in practice such as the bank enjoys limited freedom to pursue policy leading to price stability. Traditionally Bangladesh government formulates the fiscal policy and the central bank formulates the monetary policy. In the formulation of the fiscal policy sometime central bank help the government only through providing some suggestions. However Bangladesh Bank depends more on the government for formulating and implementing monetary policy.

Thus a senior policy maker of the Bank thinks that the Bank is not even free to set up a sound monetary policy for the country. Other policy makers emphasized that even Bangladesh Bank changes its monetary policy based on the government’s guideline or interests. In addition, some bankers stated that central bank should have autonomous power to set up monetary policy with good coordination as practiced in developed countries. For this purpose a coordination council is suggested in the Bangladesh Bank Order (Amendment), 2003.

However the structure of the coordination council for the coordination of fiscal, monetary and exchange rate policy makes the autonomy limited. In the coordination council, among six members only the governor represents the Bank. Five other members are officials from the Minister of Finance and government. Though theoretically it is a good step but practically it does not ensure greater autonomy of the central bank. Because through these members the party in power can practice greater control over monetary, fiscal and other policy of the Bank.

If the governor considers any policy as contradictory to the country’s economic welfare and supportive to the political benefit, he would not be able to pursue to alter or modify the policy as other group is in strong position may be with different views. Hence these reduce the autonomy of Bangladesh Bank. However the Bank has own the full autonomy in respect of foreign exchange policy. The Bank is fully practicing its power to set up for an exchange policy. In respect of monetary instruments Bangladesh Bank enjoys partial autonomy.

Bangladesh Bank has liberalized the interest rate policy but Ministry of Finance tries to influence or advice Bangladesh Bank to change interest rate. Cash reserve ratio (CRR) and statutory liquidity ratio (SLR) are the two instruments on which Bangladesh Bank has full control. Now Bangladesh Bank does not need to seek permission from Ministry of Finance regarding CRR and SLR. Therefore, Bangladesh Bank is setting CRR and SLR independently though governor makes an informal discussion with Ministry of Finance. Bangladesh Bank performs open market operations.

It buys and sells instruments like repos and reverse-repos. A fully autonomous central bank may have its own instrument other than Treasury bills. In many developed countries central bank has its own instruments and traded in the open market. Some years ago, Bangladesh Bank tried to issue its own bill in the market. And it was widely accepted by the market. However government did not encourage the bill. An economist expressed his opinions, “government did not like the bill because it was successful and government Journal of Business Research, Vol.

7, June 2005 was in fear that government T-bill will lose the market. ” This kind of attitude further weakens the freedom of the Bank. The bank also does not have autonomy in the Open Mouth Operation. In the country it is very difficult for the central bank to use its power for refusing the government to finance budget deficit. One of the former governors of the bank identified this issue as one of the most important limitations of the Bangladesh Bank. Because even in a harmful economic situation none of the bank’s governor was able to refuse credit to the government.

Moreover, government tries to control the administrative expenditure of the Bangladesh Bank by issuing directives or instructions in order to ensure the ‘role of the government’. Hence the operational freedom of Bangladesh Bank is considerably curbed. Also a former banker who has vast experiences with nationalized commercial bank explained that “though since the induction the central bank has been playing a pivotal role in conducting monetary and credit policy to promote sustainable growth in the economy and however it does not enjoy full autonomy in respect of monetary policy which is influenced by the interventions of the government.

” However due to the pressure of the different pressure groups – who wants to see more autonomous central bank – day by day government is trying to give more autonomy to the bank. Thus as per the Bangladesh Bank Amendment Order 2003, already partial autonomy has been given to the Bank (Financial Express, 10th March, 2003). As per this amendment now the Bank will be accountable to the National Parliament instead of the executive branch. While a monetary and fiscal policy coordination council will ensure reflection and adjustment of the government’s macro-economic structure in the Bank policies.

The bill sought to ensure the Bangladesh Bank’s governor’s accountability to the Parliamentary Standing Committee on Ministry of Finance, which can ask any questions, call for any documents on the monetary policy and the activities of the Bank. According to the amendment, the governor, at least once a year or at any other instance, if so summoned, will appear before the parliamentary committee to answer questions and report on the monetary policy and other activities of the Bank.

Regarding this amendment country’s Finance Minister stated that: “The autonomy of Bangladesh Bank has been suggested to keep consistency with the international banking system and following the examples of different countries. ” (Financial Express, 10th March 2003) …………. “In no country’s central bank can enjoy complete independence and in Bangladesh our economy has yet to be self-reliant that the central bank can be given full freedom. ” (The Daily Star, 10th march, 2003).

However about these amendments several opposition members of the parliament express their view as, the autonomy of the central bank depends actually on the government’s attitude and not only on any law or amendments (Financial Express, 10thMarch, 2003). Furthermore as the formulation of the ‘parliamentary committee’ does not formulate in proper way therefore the member of this committee may not possess enough knowledge and experience in this field. Thus some of the experts in the areas of ‘central bank autonomy’ fear that compare with the members of the Ministry of Finance the parliamentary committee may not act in a proper ways.

Conclusion and recommendations The general view is that an independent central bank promotes macroeconomic stability, orderly economic growth and a stable regulatory environment. Thus in recent years many countries have strengthened their central banks accordingly. While Bangladesh has quite different socio-economic and political backgrounds, so some lessons might still be gained by analyzing the current and past approaches to this important matter. Bangladesh Bank is not a statutory organization. However under the supervision of the Ministry of Finance it enjoys partial autonomy.

This autonomy is limited in both the areas i.e. , administrative and operational autonomy. Though theoretically there is Bangladesh Bank Full Autonomy – Too Early or Too Late more power for the central bank in formulating and implementing monetary policy, in practice the power is limited. In selection of the members of the board and their dismissal the government’s monopoly power is constrain on the autonomy of Bangladesh bank. In the bank’s history none of the governor – except one – was able to continue his office for full term as because the survival of the governor is largely depend upon the ‘interest’ of the ‘party in power’.

Such as by influencing the Bank unwisely the party in power often takes credit and advances from the bank. Further due to the government persuasion the Bank also failed to issue its own bill in the market and take other decision for the better economic growth. Though it has full power in some areas of decision-making however in most of the cases the banks decision is influenced by the government. Hence the Bank is enjoying very limited autonomy. However a central bank needs to set up and implement such objectives that can secure the country’s long run economic growth.

Thus for Bangladesh Bank full autonomy and a healthy financial market the following measures should be taken immediately by the financial planner of the nation. These are, restructuring the Bangladesh Bank as statutory organization. It needs a strong constitutional base like Election Commissions in Bangladesh, which can act without any political interference. The governor of the Bangladesh Bank will be responsible for every of his responsibilities only to the parliament therefore the power of the appointment and removal (if necessary) of the governor or Deputy Governor should be given to the parliament.

From the member of Board of Directors and Coordination Council the number of government officials should be reduced. The government officials should not be more than one-third of total members of the committee. More experts from outside of this two party can be included. Bangladesh Bank should ensure its own earning to meets its own expenses. Because more the bank will dependent on government for its own expense more the government will try to secure control over the operation of the bank. Hence the bank needs to reduce its dependency from government and should try to meets expenses from own source.

Only the institutional autonomy alone is not sufficient for a central bank. To be full control over monetary policy the central bank also needs to be functionally independent. Parliamentary Standing Committee must be consisting of experts in this field and if needed, experts from outside also should be included in the committee. Without any external influences more qualified and efficient management-staff-officers are need to be recruited by the Bank. Government and other political parties should act together and also co-operative each other for the operational and administrative autonomy of the bank.

However it is not only the induction of new law or amendments of existing law that will ensure the sound operation of the central bank. For the operational and administrative success of the bank, not only the party in power but also the attitude Journal of Business Research, Vol. 7, June 2005 of opposition political parties’ needs to be changed. Thus the Bank administrators need to be free from all kinds of direct or indirect political pressures. However the real challenge that facing by the Bangladesh Bank is how to evaluate and implement a popular consensus against economic stability. Therefore in practice institutional framework of the bank-government relationship is likely to be more important.

Until this is achieved, it may be little difference whether the parliament authority controls the bank or the party in power controls the Bangladesh Bank. Bibliography: ? The Bangladesh bank Order, 1972. ? The Bangladesh Bank (Amendment) Act, 2003. ? Financial Express ? The Daily Star ? http://www. bangladesh-bank. org/ ? Central bank independence ,Prepared for the New Palgrave Dictionary, December 2005 ? http://www. economist. com/blogs/freeexchange/2008/06/central_bank_independence [pic].