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79

Thoughts on Economics

Vol. 22, No. 04

VEC Models

Md. Nezum Uddin*

ABSTRACT

This study examines the medium term forecasting of inflation rate for

the Bangladesh economy using four macroeconomic variables

employing annual data from 1981 to 2011.The methodology

employed in this paper uses unit root test and Johansens cointegation

tests followed by vector error correction (VEC) model, variance

decompositions (VDCs) and impulse response functions (IRFs)

techniques to examine dynamic relationship among the variables.

Three different vector error correction (VEC) models are estimated

starting from a two-variable model including money supply and CPI,

and sub-sequentially adding some financial variables such as real

GDP and nominal exchange rates. The analysis also uses diagnostic

tests, Portmanteau test and ARCH (multivariate) test, for choosing

comparatively more stable VAR (Vector Autoregressive) or VEC

models. The results show that there exists a statistically significant

long-run positive relationship between inflation and broad money

supply for the country as indicated by a statistically significant longrun positive relationship between CPI and broad money supply. The

empirical evidence also demonstrates that the shock in LRGDP and

LNER has no significant impact on LCPI. This also suggests that

Real GDP and nominal exchange rate has no forecasting power of

inflation in Bangladesh. With a view to containing medium-term

inflationary pressure, the continuation of existing cautious policy

stance of Bangladesh Bank may therefore be recommended. These

results have also important policy implications for both domestic

policy makers and development partners working .for the country.

Keywords: Cointegration, VAR, VEC, Macroeconomic variables,

Diagnostic checking, Variance decompositions (VDCs), Impulse

response functions (IRFs), Forecasting.

1. INTRODUCTION

80

business and government. The increasing complexity of markets is fueling

the demand for professionals who possess an understanding of the

forecasting needs of organizations, the econometric tools to solve

forecasting problems, and the necessary computer skills to generate optimal

forecasts. Successful implementation and persuasion of monetary policy

largely depends on the efficiency and accuracy of forecasting major

macroeconomic events like inflation.

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 has gone up, and so has the

cost of living. Inflation in FY11 rose by 8.8 percent from 7.3 percent in the

previous year. Point to point basis CPI inflation rose to 10.2 percent at the

end of FY11 from 8.7 percent at the end of FY10.

In this backdrop the paper attempts to measure and justify the overall stance

of monetary policy, considering not only the development of inflation, but

also other variables such as Broad Money, Real GDP, and Nominal

Exchange rate. Forecasts of inflation will represent a key ingredient in

designing policies which are geared toward the achievement of price

stability.

2. RELATED LITERATURE

In the context of both developed and developing countries, there have been

extensive theoretical and empirical researches to date that attempt to focus

on the relationship between inflation and relevant economic variables and

also forecasting of them. This section presents a brief review of some

available research works.

Callen and Chang (1999) forecast inflationary trends in India by estimating

two models that describe the inflationary process in India one is based on a

monetary approach and the other on output gap model. Callen and Chang

(1999) find that two monetary aggregates (M1 and M3) contain best

information about future inflation. The output gap model does not perform

well on Indian data. Hoffmaister (1999) makes an empirical exploration in

order to assess the predictability of inflation in Korea. He uses the VAR

model to calculate impulse responses to exogenous monetary policy. He

finds that inflation in Korea is as predictable as it was in inflation targeting

countries prior to their adoption of inflation targeting and concludes that the

empirical evidence supports the feasibility of inflation targeting in Korea.

Mallik and Chowdhury (2001) examine the short-run and long-run

dynamics of the relationship between inflation and economic growth for four

Thoughts on Economics

81

applying co-integration and error correction models. They find that the

relationship between inflation and economic growth is positive and

statistically significant for all four countries and the sensitivity of growth to

changes in inflation rates is smaller than that of inflation to changes in

growth rates.

Sweidan (2004) examines whether the relationship between inflation and

economic growth has a structural breakpoint effect or not for the Jordanian

economy from the period between 1970 and 2003. He finds that this relation

tends to be positive and significant below an inflation rate of 2-percent and

the structural breakpoint effect occurs at an inflation rate equal to 2-percent.

Mubarik (2005) estimates the threshold level of inflation for Pakistan using

an annual data set from the period between 1973 and 2000. He employed the

Granger Causality test as an application of the threshold model and finally,

the relevant sensitivity analysis of the model. His estimation of the threshold

model suggests that an inflation rate beyond 9-percent is detrimental for the

economic growth of Pakistan. Thereafter Hafer and Hein (2005) compare

the relative efficiency of the widely used interest rate based forecasting

model and univariate time series model based on monthly data from the

United States, Belgium, Canada, England, France and Germany for the

sample period from 1978 to 1986. Using monthly data on the Euro rates and

the consumer price index (CPI) their results indicate that time series forecast

of inflation model produces equal or lower forecast errors and has unbiased

predictions than the interest rate based forecasts. Daoud et al (2008)

examine the long and short run equilibrium relationships between prices in

Palestine, money supply and prices in Israel by applying time series analysis

that includes cointegration for single equation, Johanson procedure for

multivariate cointegration system, and Granger causality analysis. The data

cover the periods 1970 to 2007. The result of the Granger causality test

results show that the prices in WB Granger cause for the prices in GS while

this is not true in the opposite direction.

The main objective of the paper is to forecast Bangladeshs inflation using

VAR and VEC model. To fulfill the same, the following sub-objectives are

shown:

82

Johansen cointegration test

Applying VAR or VEC techniques to display the economic relationship

among consumer price index, nominal exchange rate, real GDP, broad

money supply in Bangladesh

Forecasting the data using best fitted model

Finally, making recommendations that can assist future policy in

Bangladesh

4.1 DATA

This study has made use of secondary data analysis, and data on the CPI,

broad money supply and the nominal exchange rate are collected from

Bangladesh Bank, Monthly Economic Trend, and on real GDP are collected

from various issues of Statistical Yearbook of Bangladesh, Bangladesh

Bureau of Statistics, and Bangladesh Economic Review. To estimate the

autoregressive parameters of the models, annual data from 1981 to 2011 are

used. Here, real GDP is calculated at 1995-96 constant market prices, while

the base year for CPI is 1995-96, i.e., 1995-96 = 100. All the variables are in

logarithm form. Definitions of the variables are, LCPI = Log of Consumer

Price Index, LM2 = Log of Broad money supply, LRGDP= Log of Real

GDP, LNER = Log of nominal exchange rate

4.2 RESEARCH METHODS

In this paper a series of tests such as unit root, cointegration, diagnostics test,

vector error correction models (VECM) have been carried out. Granger

causality test was also conducted to test the causality. These tests examine

both long-run and short-run relationships between consumer price index and

the economic variables. The VECM analyses provide some support for the

argument that the lagged values of macroeconomic variables have a

significant influence on the inflation. They also provide important

information to forecast future values of the inflation. Econometric Software

Programming R is used for finding the estimates.

4.3 LAG LENGTH SELECTION

Thoughts on Economics

83

using model selection criteria. The three most common information criteria

are the Akaike (AIC), Schwarz-Bayesian (BIC) and Hannan-Quinn (HQ).

The AIC criterion asymptotically overestimates the order with positive

probability, whereas the BIC and HQ criteria estimate the order consistently

under fairly general conditions if the true order p is less than or equal to p max.

From Table 4.1, Log of real GDP has lagged one and all other selected

variables have lagged two.

Table 4.1 Lag Length Selection

LM2

Lag

AIC

-7.090

-7.238

-7.167

-7.151

-7.073

BIC

-7.050

-7.184

-7.099

-7.069

-6.978

HQ

-6.944

-7.043

-6.923

-6.858

-6.7318

LRGDP

Lag

AIC

-9.845

-9.767

-9.698

-9.619

-9.689

BIC

-9.804

-9.713

-9.630

-9.538

-9.594

HQ

-9.698

-9.572

-9.454

-9.3267

-9.3478

LNER

Lag

AIC

-6.8877

-7.359

-7.3014

-7.2376

-7.327

BIC

-6.847

-7.3053

-7.2338

-7.156

-7.232

HQ

-6.741

-7.164

-7.0576

-6.9451

-6.9859

LCPI

Lag

4.4

AIC

-7.539

-7.838

-7.7616

-7.8135

-7.7548

BIC

-7.49849

-7.784

-7.694

-7.7323

-7.660

HQ

-7.3927

-7.6436

-7.5178

-7.5209

-7.4135

ORDER

STATIONARITY

OF

DIFFERENCING

AND

TESTING

FOR

84

In Table 4.2, results of the unit root tests on concerned variables have been

reported. The tests for non-stationarity show that LCPI is non-stationary

based on ADF, PP, and KPSS tests. The first difference of LCPI is stationary

based on PP, and KPSS tests although the ADF test fails. Since the PP and

KPSS tests are preferable to ADF it can be concluded that LCPI is also

stationary, I (1). The results also shows that at 5% significance level all the

other variables are non stationary at levels since the calculated tau values are

less in absolute terms than their critical values and the variables are found to

be stationary only when tested at first difference. Thus, they are integrated of

order one -I (1). Each of these variables becomes stationary if it is

differenced once.

Table 4.2 Unit Root Test Statistics

Variab

les

LCPI

LRGD

P

LM2

LNER

Level/di

fference

L

a

g

s

ADF

PP

KPSS

Intercep

t

Intercept

& Trend

Interce

pt

Intercep

t

&

Trend

Intercept

Intercept

& Trend

DECISIO

N

Level

-1.22

-3.2118

-2.90

-3.2911

1.0802

0.2282

Non

stationary

First

Differen

ce

-2.13

-1.5514

-3.65*

-3.5418*

0.5205***

0.1938***

Stationary

Level

2.177

2.3703

0.4841

-3.15

1.0834

0.242

Non

stationary

First

Differen

ce

1.37

-0.5595

-8.69*

-11.75*

0.1375

0.06*

Stationary

Level

0.0344

-2.2516

-0.984

-2.3617

1.0907

0.1442***

Non

stationary

First

Differen

ce

-4.032*

3.2358**

-3.08*

-3.23**

0.2172*

0.1745***

Stationary

Level

-2.0322

-3.5534

1.874

-2.4843

0.4317*

0.0715***

Non

stationary

First

Differen

ce

-3.4622*

-3.3897**

3.00*

-2.9827

0.1375**

0.0569***

Stationary

Notes:

1. L means the series in log level, * and ** means significant at 5-percent and

10- percent levels, respectively.

Thoughts on Economics

85

2. Lag length for ADF tests have been decided on the basis of AIC.

3. Maximum Bandwidth for PP and KPSS tests have been decided on the basis

of Newey-West (1994).

4. All tests have been performed on the basis of 5-percent significance level

using R version 2.12.2

5. The ADF and PP tests are based on the null hypothesis of unit roots while

the KPSS test assumes the null hypothesis of stationarity.

6. For KPSS test, *, ** & ***means the null hypothesis accepted at 1percent,

-percent and 10- percent levels, respectively.

4.5 GRANGER CAUSALITY TESTS

Table 4.3 shows the results of the Granger causality test conducted for the

respective variables of the model. The null hypothesis in each case is that the

variable under consideration does not Granger cause the other variable.

Table 4.3 is analyzed at 5% significance level. The tests found that money

supply does Granger cause consumer price index (inflation rate). It is

evident, therefore, that the direction of causality runs from money supply to

consumer price index. Hence the causality here is unidirectional.

Bidirectional causality was found between LGDP and LCPI (inflation rate).

Unidirectional causality was found between LNER and LCPI (inflation rate).

It is evident, therefore, that the direction of causality runs from nominal

exchange rate to money supply. Hence, causality is unidirectional. The test

also found that nominal exchange rate does Granger cause real GDP. Hence,

causality is unidirectional.

Table 4.3 Results of Pair wise Granger causality Tests

86

Null Hypothesis:

F-Statistic

p-value

2.0461

0.0314*

0.2084

0.0427*

0.8233

0.4456

3.2118

0.0498*

0.8806

0.4217

5.018

0.0108*

0.2473

0.7820

LNER does

LRGDP

5.5143

0.0073*

7.5977

0.0014*

0.2377

0.7894

1.2925

0.2848

1.7277

0.1895

not

Granger

cause

This study examines both long run and short-run relationship among

consumption price index and the macroeconomic variables and forecast on

them. Here three different models have been considered. In the model,

consumption price index (CPI) is considered as dependent variable and real

gross domestic product (RGDP), broad money (M2), the nominal exchange

rate (NER) as independent variable. All variables are transformed into

natural logs. We expect that there will be long-run cointegrating

relationships between the variables consistent with macroeconomic

fundamentals. Further, there should be short run relationships between these

variables. The forms of these variables in the model are in the order of

integration one I (1), which is explained in Table-4.2 and Table-4.3. So the

models are as follows.

LCPIt=

1+11

LM2

.1

LCPIt=

2+21

LM2t+

22

.2

LRGDPt

e1t

+

e2t

Thoughts on Economics

87

3

4.7 DIAGNOSTIC TESTS OF VAR (P)

Given the diagnostic test results from table 4.4, we conclude that a VAR (1)

specification might be too restrictive for all three models. Although some of

the stability tests do indicate deviations from parameter constancy, the timeinvariant specification of the VAR (2) for model-1 and model-3 and VAR (3)

for model-2 will be maintained as tentative candidates for the following

cointegration analysis.

Table 4.4 Diagnostic tests of VAR (p)

Variable

lag

Model

LCPI,

-1

LM2

LCPI,

Model

-2

-3

Test

p~value

MARC

H

p~value

Portmant

eau Test

p~value

p=3

3.3182

0.5061

52.2033

0.2143

42.8488

0.8132

p=2

3.6733

0.452

47.944

0.3543

46.2872

0.8194

p=1

15.879

0.003186

39.9147

0.6867

61.8743

0.409

p =4

0.1081

0.9908

126

0.9992

106.1218

0.5331

p=3

6.1175

0.1060

132

0.9971

114.8545

0.5388

p=2

23.534

3.125e-05

138

0.9913

105.3269

0.9096

p=1

18.874

0.0002903

144

0.9775

124.7901

0.7247

p =4

10.810

0.2127

210

232.3488

0.02478

p=3

6.7492

0.5639

220

201.4034

0.6157

LM2,

LRGDP

Model

JB-

LCPI,

LM2,

LRGDP,

88

LNER

p=2

21.627

0.1356

230

179.3016

0.9874

p=1

53.567

8.377e-09

240

222.0211

0.7914

From table 4.5 the computed the maximum Eigen value test statistics and

their corresponding critical values indicate that the null hypothesis of no cointegration (r = 0) can be rejected under both of these tests at both 5-percent

and 1-percent levels of significance. According to the maximum Eigen value

test we conclude that there is one co-integration equation at 1- percent levels

of significance for model-3 (p = 2). This implies a long-run relationship

between inflation and broad money in Bangladesh for model-1, a long-run

relationship among inflation, broad money and real GDP in Bangladesh for

model-2, and a long-run relationship among inflation, broad money, real

GDP and the nominal exchange rate in Bangladesh for model-3.

Table 4.5 Johansen Test for Co-integration (Maximum eigen value Test)

Test

Variable

H0

H1

Statistics

Critical Values

Conclusion

Thoughts on Economics

89

r<=1

r=2

23.16

28.76

23.11

25.54

30.34

r<=2

r=3

11.98

14.98

16.85

18.96

23.65

r<=3

r=4

10.22

12.01

10.49

12.25

16.26

MODEL-1

The Vector Error Correction Model (VECM) allows us to make inferences

on the long-run impacts of the variables in levels to those in differences. The

variables of the model-1 are one co-integrating equation; then there exists an

error correction model (i.e VEC (2) with r=1) that may take the following

form

Model---1

LCPIt=11+11

LCPIt-1+

1a

12

LM2t=12+21

LCPIt-1+

..1b

2t

12

LM2t-1+

LM2

Dt

+

t-1

+1t

Dt+

The estimated coefficients of the error correction term (long-run effects) and

the lagged values of the two series (short-run effects) are presented in Table

4.6.

Table 4.6.The Error Correction Model-1

Variables equations

LM2t-1

LM2t

LCPIt

-0.3039

0.02501

(0.0590)

(0.03733)

{-5.151*}

{-0.670}

[2.83e-05]

[0.50918]

2.6801

-0.2063633

(0.5103)

(0.3228424)

{5.252 *}

{-0.639}

[2.20e-05]

[0.52874]

0.1794739

0.2075785

(0.1297705)

(0.0821030)

90

{1.383}

{2.528*}

[0.179]

[0.01845]

0.2840767

0.4338898

(0.2080724)

(0.1316429)

{1.365}

{3.296*}

[0.185]

[0.00304]

Multiple R-squared:

0.9677

0.9323

Adjusted R-squared:

0.9623

0.921

179.8

82.59

p-value: 1.135e-13

0.0321

0.02031

LCPIt-1

F-statistic:

Residual standard error:

respectively, and * & ** indicate significant at 1-percent and 5- percent

levels, respectively, comparing critical value of t-statistics.

The empirical results show the existence of short-run and long-run

relationships between CPI and M2 in Bangladesh. This also implies shortrun and long-run relationships between inflation and broad money supply in

the country. The estimated coefficients of the error correction term is

significant at 1-percent level from M2 to CPI and vice versa with

appropriate (i.e., negative) signs. This means that in the long-run if the two

series are out of equilibrium, M2 will adjust to reduce the equilibrium error

and vice versa is not significant in the model-1. In other words, it shows that

30 percent (error correction term -0.3039) of the deviation of the M2 from

its long run equilibrium level is corrected each year. The estimated results in

the ECM also show that a short-run change in CPI and M2 affect M2

positively and statistically insignificant, and vice versa is significant with

positive in sign.

Table 4.7. Diagnostic checking For VEC (2) with one cointegrating

equation and VEC (3) with one cointegrating equation for model-2

Name of the test

Chi-squared value

df

p-value

Thoughts on Economics

1. Normality test(JBTest)

2.

serial

correlation

test(Portmanteau Test)

3.ARCH (multivariate)

91

VEC (2)

VEC (3)

VEC (2)

VEC (3)

VEC (2)

VEV (3)

with r=1

with r=1

with r=1

with r=1

with r=1

with r=1

0.338

0.5926

6.8183

4.626

93.9629

106.36

129

120

0.9912

0.8085

138

132

180

180

0.9913

0.9971

The diagnostic tests for the VECM equation confirmed its coefficient

stability. The Jarque-Bera test did not reject the null hypothesis of a normal

distribution of the residuals (at 5 percent significance level) and the

Portmanteau test as well as the correlogram of squared residuals did not

show any autocorrelation or ARCH in the residuals. The short-run Dynamic

Adjustment using VEC for model-1 and model-3 has been also done,but it is

not shown in this paper.

Forecasted points estimates of each model by making necessary adjustments

based on the latest available information for the selected macroeconomic

variables are reported in Table 5.1. The forecasted outcome for inflation of

the current study from model-3 indicates that the rate of inflation will be

about 6.86 percent, 5.28 percent, 5.72 percent, 6.25 percent and 6.23

percent, respectively, in fiscal year 2011-12, 2012-13, 2013-14, 2014-15,

and 2015-16 as against 8.8 percent in fiscal year 2010-11, which are on

average the same as the predicted inflation as shown in the medium term

macroeconomic framework (Ministry of Finance, 2010). On the other hand,

the broad money supply is predicted to grow by 11.64 percent, 14.73

percent, 17.08 percent, 16.07 percent and 15.16 percent, respectively, in

fiscal year 2011-12, 2012-13, 2013-14, 2014-15,2015-16, as against 21.4

percent in fiscal year 2010-11. And the forecasted Real GDP growth will be

92

about 6.94 percent, 6.43 percent, 5.81 percent, 5.55 percent and 5.50

percent, respectively, in fiscal year 2011-12, 2012-13, 2013-14, 2014-15,

2015-16 as against 6.7 percent in fiscal year 2010-11. And the forecasted

Period Average Exchange rate will be about 77.78 Taka/USD, 80.42

Taka/USD, 83.46 Taka/USD, 86.89 Taka/USD and 90.3 Taka/USD,

respectively, in fiscal year 2011-12, 2012-13, 2013-14, 2014-15, 2015-16 as

against 74.15 Taka/USD in fiscal year 2010-11. A gradual depreciation of

Taka-USD will occur in the medium term in line with current policy

intervention (Table 5.1).The findings of model-1 and model-2 shown in

Table 5.1

Forecast

value for

model-2

on

15.

9

408995

.7

6.2

2

16.

78

432959

.7

5.8

6

Infl

atio

n

Rat

e

Broad

Money

(M2)(Taka

in crore)

M2

Gro

wth

20112012

261.4

4

8.4

7

523996.

35

18.

95

20122013

282.6

8

8.1

3

611573.

24

16.

71

20132014

304.3

2

7.6

5

703139.

09

14.

97

20142015

326.0

8

7.1

5

801187.

27

13.

94

20152016

348.0

1

6.7

2

909872.

72

13.

57

20112012

260.7

5

8.1

8

510542.

93

20122013

279

596234.

9

Year

Forecast

value for

model-1

on

VEC(2)

Real GDP

(Taka in

crore)

Rea

l

GD

P

Gro

wth

CPI

(Base:

19951996)

NER

NE

R

Gro

wth

Thoughts on Economics

VEC(2)

Forecast

value for

model-2

on

VEC(3)

Forecast

value for

model-3

on

VEC(2)

93

201

3201

4

297.6

1

6.6

7

705674.

95

18.

36

456968

.6

5.5

5

20142015

318.0

8

6.8

8

838340.

82

18.

8

481128

.7

5.2

9

201

5201

6

340.7

5

7.1

3

991803.

22

18.

31

505816

.9

5.1

3

20112012

250.4

3.8

9

498380.

94

13.

13

412800

.6

7.2

1

20122013

259.7

5

3.7

3

577746.

23

15.

92

439340

.5

6.4

3

20132014

277.5

6

6.8

6

689119.

52

19.

28

464046

.5

5.6

2

20142015

298.9

4

7.7

809352.

64

17.

45

489544

.2

5.4

9

20152016

319.4

2

6.8

5

937423.

09

15.

82

516303

.5

5.4

7

20112012

257.5

6

6.8

6

491796.

36

11.

64

411790

.5

6.9

4

77.

78

4.9

20122013

271.1

5

5.2

8

564254.

12

14.

73

438283

6.4

3

80.

42

3.4

20132014

286.6

4

5.7

2

660650.

34

17.

08

463749

.6

5.8

1

83.

46

3.7

8

20142015

304.5

7

6.2

5

766814.

35

16.

07

489505

5.5

5

86.

89

4.1

1

20152016

323.5

5

6.2

3

883070.

22

15.

16

516442

.9

5.5

90.

3

3.9

3

one-year time horizon, money supply explains around 0.11%, real GDP

explains 0.91%, and period exchange rate explains 2.37% of the total

variation of inflation rate while 96.61% of variations in prices are explained

by their own shock. At the five- year horizon, money supply explains 2.87%,

real GDP explains 0.44%, and nominal exchange rate explains 13.51% of

the total variation of inflation rate and 83.18% of variations in prices are

explained by their own shock. At all time horizon, more than 4.56% of the

variance in prices is explained by money supply while their own innovations

94

explain 84.94% and real GDP explain 0.6%, period exchange rate explains

9.90%.Therefore, The shock in LM2 has a positive impact on LCPI for all

time periods. The shock in Real GDP has a negative impact on LCPI for

medium term periods.

Table-5.2. Variance Decomposition for VEC model of LM2, LRGDP,

LNER and LCPI.

Variance Decomposition of LM2

Forecast

LM2

LRGDP

LNER

LCPI

1.0000000

0.00000000

0.00000000

0.000000000

0.9281112

0.04691942

0.02190837

0.003060972

0.8730181

0.11087654

0.01199048

0.004114879

0.8243135

0.14594943

0.01454673

0.015190304

0.7932603

0.16294092

0.01909392

0.024704818

0.7711308

0.17530461

0.02219857

0.031366073

0.7518035

0.18553372

0.02552378

0.037139008

0.7351727

0.19332417

0.02914722

0.042355903

0.7215745

0.19918010

0.03247602

0.046769331

10

0.7104130

0.20382182

0.03534363

0.050421531

Horizon

Forecast

LM2

LRGDP

LNER

LCPI

0.6306442

0.3693558

0.000000000

0.000000000

0.6179559

0.3686398

0.005048734

0.008355577

0.6392246

0.3419106

0.004911274

0.013953483

0.6640160

0.3182072

0.003460403

0.014316414

0.6803065

0.3017387

0.004649569

0.013305183

0.6908565

0.2895759

0.007287709

0.012279853

0.6986915

0.2793220

0.010689863

0.011296607

0.7046832

0.2703145

0.014670275

0.010332046

0.7091762

0.2624614

0.018922521

0.009439930

10

0.7125851

0.2556078

0.023155961

0.008651171

Horizon

Forecast

LM2

LRGDP

LNER

LCPI

Thoughts on Economics

95

Horizon

1

0.02073619

0.04086744

0.9383964

0.000000000

0.04963582

0.04745808

0.8989852

0.003920943

0.06558947

0.06173850

0.8652608

0.007411260

0.07131477

0.07378131

0.8474333

0.007470586

0.07439737

0.08127628

0.8378113

0.006515078

0.07734745

0.08639471

0.8306029

0.005654945

0.07997100

0.09052459

0.8245386

0.004965796

0.08205271

0.09394412

0.8196184

0.004384773

0.08372893

0.09672721

0.8156489

0.003894935

10

0.08514613

0.09901781

0.8123473

0.003488789

Forecast

LM2

LRGDP

LNER

LCPI

0.001113351

0.009082615

0.02367268

0.9661314

0.009912304

0.013689889

0.08065954

0.8957383

0.020136422

0.009216613

0.12917521

0.8414718

0.025051094

0.005884118

0.14077007

0.8282947

0.028676439

0.004392340

0.13514071

0.8317905

0.032599881

0.003880304

0.12682869

0.8366911

0.036470520

0.003996506

0.11905307

0.8404799

0.039907461

0.004515394

0.11176028

0.8438169

0.042920881

0.005230819

0.10501476

0.8468335

10

0.045602550

0.006018612

0.09900500

0.8493738

Horizon

Figure5.1 shows the impulse response functions (IRF) for four variable VEC

model. The IRF results show that, the shock in LM2 has a positive impact on

LCPI for all time periods. Therefore, a positive shock to money supply

persistently raises the CPI in the long run. The shock in LRGDP and LNER

has no significant impact on LCPI. This suggests that nominal exchange

rate has no forecasting power of inflation in Bangladesh. The response of

prices to their own shocks is again positive and significant at all time periods

and persistent indicating the inflation inertia. The same finding is also done

for model-1 and model-2, which is not reported in this paper.

96

Figure 5.1 Impulse Responses for VEC (2) models of LM2, LRGDP,

LNER and LCPI

6. CONCLUSIONS AND POLICY IMPLICATIONS

The main objective of the study is to find out the significant factors behind

inflation in the context of Bangladesh during the period FY 1981- FY 2011

and forecasting the data to Medium-Term Outlook (FY 2012- FY 2016). In

this regard, the paper studies the historical trends of inflation and other

macroeconomic variables such as money supply growth, exchange rate

depreciation, real GDP and their relationship. It is observed that Bangladesh

experienced a moderate level of inflation during FY 1992 to 2006. On the

other hand, Bangladesh faced two digit inflation rate most of the time during

FY 1982 to 1991. In regard to cause and sources of inflation, the data reveal

that money supply growth, real GDP growth and exchange rate depreciation

appear significant. The empirical findings strongly support the historical

data that inflation in Bangladesh during FY 1981 FY 2009 was a monetary

phenomenon. The outlook of the model-1 is that the annual average inflation

Thoughts on Economics

97

will cruise within 8.47 percent in FY2011-12 and is forecast to fall gradually

to 6.72 percent by FY 2015-16 which is higher than our expectation, but

forecast values of inflation for model-2 and model-3 are stable. In particular,

VDCs support the view that money supply has an explanatory power of

forecasting the movements in consumer price index (CPI). Also, IRFs show

a positive influence of money supply on inflation rate, which is very much in

line with the outcome of VDCs. So authorities should be cautious while

increasing money supply in the market if they want order to control the

inflation any pressure in the country. From the analysis, we found that if the

government wants to control the inflation rate below 6% in the next five

year, supply of money should not exceed 13% each year. The results from

IRFs and VDCs suggest that the real GDP has a moderate short run negative

impact on inflation rate. So care should be taken so that real GDP does not

fall to keep the inflation as it is. It has also been found that exchange rate

depreciation has a small positive impact on inflation; monetary policy

authority should therefore remain vigilant to prevent erosion of the

exchange rate. In the absence of any direct controlling instrument,

Bangladesh Bank can initiate some case specific counter-action. For

example, it can undertake some responsibilities such as monitoring

modalities of Letter of Credit (L/C) operation so that market forces

determine the exchange rate in a process that remains free from much

speculative transactions.

Empirical results of this study suggest that direct linkages between monetary

policy instrument and inflation appear strong, stable and predictable in

Bangladesh. This study presents clear evidence that the contribution of

money supply is more significant than other variables such as real GDP and

nominal exchange rate.

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