[Cover page]

Policy Analysis Unit (PAU)

Working Paper Series: WP 0902






Impact!of!Monetary!Policy!Changes!in!a!Semi"Global!Economy:!!
Evidence!from!Bangladesh!




Sayera Younus







February 2009








Policy Analysis Unit (PAU)
Bangladesh Bank
Head Office, Dhaka, Bangladesh
(www.bangladeshbank.org.bd)
(www.bangladesh-bank.org)













Policy Analysis Unit* (PAU)






Working Paper Series: WP 0902





Impact!of!Monetary!Policy!Changes!in!a!Semi"Global!Economy:!!
Evidence!from!Bangladesh!



Sayera Younus







February 2009






Copyright 2009 by Bangladesh Bank

* In an attempt to upgrade the capacity for research and policy analysis at Bangladesh Bank (BB),
PAU prepares and publishes Working Papers on macroeconomic issues as a part of its routine
activities. These papers reflect research in progress, and as such comments are most welcome. It is
expected that these papers would eventually be published in learned journals after undergoing due
review process. Neither the Board of Directors nor the management of, or any agency of the
Government of Bangladesh necessarily endorses any or all of the views expressed in these papers. The
latter reflects views based on professional analysis carried out by the staff of Bangladesh Bank, and
hence the usual caveat of research reports applies.

[An electronic version of this paper is available at www.bangladeshbank.org.bd]
Impact!of!Monetary!Policy!Changes!in!a!Semi"Global!Economy:!!
Evidence!from!Bangladesh!

Sayeia Younus
1


Abstract!
!
The!study!examines!the!impact!of!changes!in!monetary!policy!in!Bangladesh.!Specifically,!
the!study!examines!the!impact!of!domestic!and!foreign!monetary!shocks!on!Bangladeshs!
major! economic! aggregates.! In! the! context! of! a! semi"global! economy! such! as!
Bangladesh,! the! conduct! of! monetary! policy! becomes! increasingly! more! difficult! as!
globalization! proceeds.! It! becomes! important! to! examine! the! impact! of! changes! in!
relevant! 'foreign'! variables! (e.g.,! interest! rate,! money! supply,! exchange! rate)! while!
formulating! domestic! monetary! policy.! The! empirical! results! of! the! present! analysis!
show!that!innovations!to!foreign!money!supply!have!significant!impacts!on!Bangladesh's!
real! exchange! rate,! interest! rate,! and! output.! However,! foreign! money! supply! does! not!
create! much! impact! on! Bangladeshs! money! supply! or! price! level.! ! The! results! also!
indicate! that! innovations! to! Bangladeshs! money! supply! have! significant! impact! on!
Bangladeshs!interest!rate,!price!level,!and!output.!!!
!




Key Woius: Nonetaiy Policy, Nacioeconomic vaiiables.
}EL Classification: ES2, E6S

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
1
Senior Research Economist, Policy Analysis Unit, Bangladesh Bank. Email:
sayera33@yahoo.com. The author would like to thank Dr. Mustafa K. Mujeri, Chief Economist for
his valuable comments and suggestions on earlier drafts of the paper. Any remaining errors are,
however, the author's own.




1
Impact!of!Monetary!Policy!Changes!in!a!Semi"Global!Economy:!
Evidence!from!Bangladesh!
I. Introduction!
!
n the context of giowing openness of the uomestic economy anu incieasing
integiation with the iest of the woilu, global economic anu financial uevelopments
touay make monetaiy policy uecisions moie complex than it was befoie. This papei
aims to iuentify the impact of monetaiy policy changes iesulting fiom both inteinal anu
exteinal souices to assist in foimulating sounu monetaiy policy anu incieasing the
iesilience of the uomestic economy to cope with changing global enviionment. Such
consiueiations aie impoitant foi a small open economy like Banglauesh which is
extiemely vulneiable to exteinal factois incluuing policy changes abioau.
Theie aie thiee impoitant factois that ueteimine the extent to which a uomestic
economy can become vulneiable to foieign shocks e.g., the uegiee of integiation of
financial anu goous maikets, the ielative size of the economy, anu the exchange iate
iegime. In this context, Paiiy (1998) concluues that "....greater!integration!of!financial!and!
goods! markets! has! increasingly! subjected! domestic! economies! to! the! effects! of! changes! in!
economic!conditions!abroad!and!has!importantly!affected!the!monetary!policy!transmission!
mechanism.! However,! these! developments! do! not! imply! that! domestic! monetary! policy! is!
necessarily!less!effective...".
In this backuiop, the stuuy examines the impact of both uomestic anu foieign
monetaiy policy changes on Banglauesh's economic aggiegates. In this papei, Inuia's
money supply is useu as the measuie of foieign monetaiy policy change. The iationale foi
using Inuia's money supply iests on possible contagious cioss boaiuei effects. Inuia's
economy is laige ielative to that of Banglauesh anu Banglauesh shaies most of its boiuei
with Inuia; Inuia also is one of oui majoi tiauing paitneis. Theiefoie contagious effect
thiough boiuei anu tiaue can have significant impact on uomestic macioeconomic
vaiiables paiticulaily inflation anu output.
The papei is oiganizeu as follows. The intiouuction of this section is followeu by a
ieview of the ielevant liteiatuie in section II. In section III, Banglauesh's tiaue pattein
coveiing majoi tiauing paitneis is analyzeu. Section Iv pioviues a compaiative view of
the monetaiy policies puisueu by Banglauesh anu Inuia. Nethouological consiueiations,,
mouel vaiiables anu empiiical iesults aie uiscusseu in section v while section vI pioviues
the conclusions.
I

2
II. !A!Brief!Review!of!the!Literature!
To unueistanu the impact of monetaiy policy, one shoulu examine the
inteiuepenuence among policy anu taiget vaiiables. Two stianus of liteiatuie aie
ielevant. Fiist, the liteiatuie that uiscusses the ielationship among uomestic money,
the piice level, inteiest iate, exchange iate anu output. Seconu, the liteiatuie that
ueals with the impact of foieign monetaiy policy on the uomestic macioeconomic
vaiiables. An incieaseu uegiee of globalization plays an impoitant iole in
tiansmitting economic shocks fiom a laige countiy to a small countiy. In oui stuuy,
Banglauesh is a small countiy ielative to Inuia.
Nany stuuies have examineu the ielationship between monetaiy policy
effectiveness anu macioeconomic vaiiables in uevelopeu countiies. Examples of these
stuuies incluue Beinanke anu Blinuei (1992), Fiieuman anu Kuttnei (1992), Leepei,
Sims anu Zha (1996), NcCanuless anu Webei (199S), anu Sims (1992).
Relatively few stuuies have examineu the ielationship between uomestic
monetaiy policy anu macioeconomic vaiiables in ueveloping countiies such as
Banglauesh. Stuuies that uo examine monetaiy effectiveness in Banglauesh incluue
Paiikh anu Staimei (1988), Bossain (1996), anu Ahmeu (2uu2-uS).
0sing monthly uata on the cost of living inuex of Bhaka miuule-class families
(P) anu money supply (N1), Paiikh anu Staimei (1988) examine the impact of N1

on
P uuiing the peiiou 197S:2 to 1986:4. Paiikh anu Staimei's (1988) iesults show that
causality in Banglauesh iuns fiom P to N1 anu not fiom N1 to P. The iesults iemain
iobust when N2 is useu in place of N1

anu the giowth iate of the money supply anu
inflation aie useu in place of N1 anu P.


Bossain (1996) uses uata fiom 197S-1989 to examine the causal ielationship
between two uefinitions of money (N1 anu N2) giowth anu wholesale piice inuex
inflation in Banglauesh. Bossain (1996) finus uniuiiectional causality iunning fiom
N2 to WPI, but not fiom N1 to WPI. 0nlike Paiikh anu Staimei (1988), Bossain
(1996) uoes not finu eviuence of causality iunning fiom piice level to money.
Bossain's (1996) cointegiation tests show that theie aie long-iun equilibiium
ielationships between N1anu WPI anu N1

anu WPI.
Ahmeu (2uu2-uS) examines the causal ielationships between money, output,
inteiest iates, anu piice level using quaiteily uata fiom Banglauesh, Inuia, anu
Pakistan. Ahmeu's iesults aie baseu on uiangei causality tests. Foi the peiiou 1974:2
- 1998:4 Ahmeu finus that changes in Banglauesh's bioau money supply (N
2
) uo not
leau to changes in Banglauesh's output, inteiest iate, oi piice level. Bowevei, output,
the inteiest iate, anu the piice level each uiangei cause N2.
Baseu on these stuuies, we cannot ieach a conclusion iegaiuing the
ielationship between money giowth anu inflation in Banglauesh. Ahmeu (2uu2-uS)
anu Paiikh anu Staimei (1988) finu uniuiiectional causality fiom piices to money,
while Bossain (1996) finus uniuiiectional causality fiom money giowth to inflation.
It is impoitant to note that each of these stuuies suffeis fiom omitteu vaiiables. The
stuuies excluue potentially impoitant vaiiables incluuing the exchange iate anu

3
foieign vaiiables.
2
Fuitheimoie, Paiikh anu Staimei (1988) anu Bossain (1996) base
theii iesults on bivaiiate causality tests.
Incieaseu globalization plays an impoitant iole in tiansmitting economic
shocks between countiies. As stateu by Fumio (1994), policy cooiuination between
foieign anu uomestic vaiiables uuiing the 198us became veiy impoitant uue to
giowing inteiuepenuence among nations. As inteinational inteiuepenuence giows,
changes in foieign economic policies exeit gieatei influence on uomestic economies.
As a iesult, the ability of uomestic policymakeis to contiol the uomestic economy
ueclines. To measuie effectiveness of uomestic policy, it is necessaiy to consiuei the
actions of foieign policymakeis.
Nany stuuies examine the impact of foieign monetaiy shocks on
macioeconomic vaiiables in uevelopeu countiies. Examples incluue Amueuo-
Boiantes anu Wheelei (2uu1), Cushman anu Zha (1997), Nixon, Piatt, anu Wallace
(1979), Selvoi anu Rounu (1996), anu Sheehan (1992). In geneial, the liteiatuie on
foieign monetaiy policy anu uomestic macioeconomic vaiiables shows that 0.S.
monetaiy policy has a significant positive impact on macioeconomic vaiiables in
othei uevelopeu countiies. Bowevei, iesults vaiy acioss exchange iate iegimes.
Relatively few stuuies have examineu the impact of foieign monetaiy shocks
on macioeconomic vaiiables in ueveloping countiies, anu none of the existing stuuies
use uata fiom Banglauesh. Faiiell (198u) examines the impact of 0.S. monetaiy policy
on Nexico's monetaiy policy. Boffmaistei, Roluos anu Wickman (1997) examine
whethei the exteinal sectoi has an impact on macioeconomic vaiiables in Sub-
Sahaian Afiican countiies.
Faiiell (198u) shows that the 0.S. monetaiy base has a significant impact on
Nexico's monetaiy base, while the impact of the 0.S. monetaiy base on the inteiest
iate uiffeiential anu inflation uiffeiential aie not significant. Faiiell (198u) suggests
that Nexico's policy makeis shoulu keep an eye on the uiiection of 0.S. money supply,
iathei than 0.S. piices, while attempting to evaluate the impact of theii own money
supply.
Boffmaistei, Roluos anu Wickman (1997) examine the souices of
macioeconomic fluctuations in Sub-Sahaian Afiican countiies. They uiviue the
countiies into CFA fianc countiies (wheie exchange iates aie peggeu with the Fiench
fianc) anu non-CFA fianc countiies (wheie exchange iates can aujust fiequently).
Boffmaistei, Roluos anu Wickman (1997) examine whethei uiffeiences in
macioeconomic fluctuations between CFA fianc anu non-fianc countiies aie uue to
uomestic shocks oi exteinal shocks. vaiiance uecompositions anu impulse iesponse
functions, ueiiveu fiom a five-vaiiable SvAR, show that the main souice of output
fluctuations in Sub-Sahaian Afiican countiies is uomestic supply shocks. Exteinal
shocks also have some impact on the uomestic output, piices anu the ieal exchange
iate. The impacts aie gieatei in CFA fianc countiies than in non-CFA fianc countiies.
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
2
The results of Parikh and Starmer (1988) differ from those of Hossain (1996) in part due to
differences in the specification of the inflation variable. Hossain (1996) uses the wholesale price
index, while Parikh and Starmer (1988) use a consumer price index for Dhaka middle-income
families.

4
The above stuuies suggest that foieign monetaiy policy may have a stiong
impact on the uomestic economy of ueveloping countiies. Eviuence shows that
Nexican monetaiy policy is stiongly influenceu by the 0.S. monetaiy policy. Stuuies
baseu on Sub-Sahaian Afiican countiies show that exteinal shocks also have an
impact on output anu the piice level.

III. Trade!Pattern!of!Bangladesh!
Banglauesh's uiiection of tiaue to majoi tiauing paitneis is shown in Table 1. In
2uu7, Banglauesh tiaue ueficit with China was the highest followeu by Inuia,
Singapoie, Bong Kong anu }apan anu while Banglauesh enjoyeu tiaue suiplus with
0nites States anu ueimany. The uestination wise pattein of impoits unuei cash
uuiing FYu7 ievealeu that the People's Republic of China toppeu the list of supplieis.
The majoi items impoiteu fiom China weie cotton (all types), cotton yainthieau,
cotton fabiics, boileis, machineiy anu mechanical appliances, electiical machineiy etc.
Inuia is the seconu laigest suppliei followeu by Singapoie, Bong Kong anu }apan. The
main impoiteu item fiom Inuia weie cotton (all types), cotton yainthieau anu cotton
fabiics, ceieals, mineial fuels, mineial oils, boileis, machineiy anu mechanical
appliances etc. 0n the othei hanu, the 0SA was the most piominent buyei followeu by
ueimany, 0niteu Kinguom anu Fiance. The majoi expoit items weie ieauymaue
gaiments, fish, shiimps anu piawns, jute manufactuies, leathei anu leathei
manufactuies etc. Analyses of tiaue pattein ieveal that Banglauesh impoits similai
piouucts fiom all majoi impoiting countiies while the cost of impoits vaiies ovei
countiies. Inuia is the neaiest neighboi; theiefoie, impoits fiom Inuia give the
oppoitunity to impoit at low cost contiibuting to fuithei economic integiation.

Table!1:!Bangladesh!Trade!Balance!with!Major!Trading!Partners!in!2007!
TW (avg. of FYuu anu FY
u1)
Expoit
(million
0S$)
Impoit
(million
0S$)
Tiaue balance
(million 0S$)
China
u.u699 87.84 2771.64
-268S.8u
Inuia
u.17S4 2u9.71 2646.S8
-24S6.87
Singapoie
u.u8Su Su.u8 11S7.49
-1u87.41
0SA
u.21SS 29Su.68 47u.41
246u.27
Bong Kong
u.uS98 11S.SS 769.uS
-6SS.72
}apan
u.u9u6 114.4S 6SS.84
-SS9.S9
ueimany
* 1648.1 41S.68
12S4.42
TW=Tiaue weight
*Tiaue Weight foi ueimany alone is not available while tiaue weight foi total Euio
aiea is u.2S18
Souice: Direction!of!Trade!Statistics, YEARB00K 2uu8, INF.

5
Fiom Figuie 1 it is eviuent that since 199u Banglauesh's impoits fiom Inuia incieaseu
significantly fiom 4.u2 peicent to 17.86 peicent in 2uu8 while expoit incieaseu
moueiately fiom u.8S peicent to 2.46 peicent ovei the same peiiou.
Figure!1:!!Trends!in!Bangladesh's'!Export!and!Import!!

Souice:!Direction!of!Trade!Statistics,!2008,!INF publication.
It is possible that the Banglauesh economy is vulneiable to shocks fiom each
of the majoi tiauing paitneis which may tiansmit thiough eithei the level of
integiation oi ielative size of the economy oi the exchange iate policies. Since
Banglauesh's capital accounts aie not fully open, tiaue can play an impoitant iole to
tiansmit the shocks to the uomestic economy. In this papei, we use Inuian money
supply as a foieign vaiiable because Inuia is laige ielative to Banglauesh anu the level
of integiation thiough tiaue is stiong. The stuuy may be extenueu in futuie to
incoipoiate othei majoi tiauing paitneis as well.
Figure!2:!Taka/Rupee!Exchange!Rate Figure!3:!Appreciation!(+)/Depreciation!(")!
of!Taka!against!Indian!Rupee!



Source:!International!Financial!Statistics,!IMF,!2008.!
Exports!to!India!
/Exports!to!World!
,!2.46
Imports!!to!
India/Imports!to!
World!,!17.86
0.00
5.00
10.00
15.00
20.00
25.00
Q
1
!
Q
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7

6
In a small open economy like Banglauesh, the exchange iate plays an impoitant
iole in affecting macioeconomic vaiiables. In oiuei to ieuuce balance of payment
ueficits, Banglauesh uevalueu its cuiiency seveial times fiom 1972 to 2uu2.
S
Theiefoie,
besiues uomestic anu foieign money supply, this papei uses ieal exchange iate between
Banglauesh's Taka anu the Inuian Rupee to see whethei uepieciationappieciation of the
exchange iate between Taka anu Inuian Rupee hau any significant impact on uomestic
output. Figuie 2 shows the tienu of TakaRupee exchange iate while Figuie S shows the
iate of appieciation anu uepieciation Taka vis-a-vis Inuian Rupee. The figuies ieveal that
Taka lost competitiveness in the 199us uue to 22 peicent appieciation of Taka against
Rupee in QS 1991 anu fuithei in 199S. Buiing 2uu8, Taka pei Inuian iupee appieciateu
fiom u.99 peicent in Q1 2uu8 to 11.S8 peicent in Q4 2uu8.
Buiing the 199us, Taka iemaineu ielatively expensive to Rupee which among
otheis helpeu to inciease impoits fiom Inuia because Banglaueshi consumeis enjoyeu
lowei piices of impoiteu piouucts compaieu with uomestic piouucts. uiven the
potential key iole of the inteiest iate in monetaiy tiansmission mechanism, the mouel
also incluues a uomestic (Banglauesh) inteiest iate because aftei the FSRP in the 199us
libeialization of inteiest iates was a piime aiea wheie iefoims took place.
Bowevei, the peiceiveu benefits anu costs of economic integiation of a countiy
with a laigei countiy have to be seen in the context of the economy's iesilience to
possible shocks within the open economy fiamewoik anu the quality of its
macioeconomic fiamewoik anu institutions. Bence, we examine the impact of Inuia's
money supply on Banglauesh's money supply to see whethei Inuia's monetaiy policy has
any influence on Banglauesh's money supply, inteiest iate, piice level, anu output.
IV. Monetary!Policy!in!Bangladesh!and!India!!
Monetary!Policy!in!Bangladesh
4
!
Banglauesh gaineu inuepenuence in 1971. The countiy went thiough a tuibulent
peiiou of economic anu political ciisis uuiing 1974-197S. This was in the miust of a
histoiically high inflation of about 4u peicent pei annum uuiing 1972-197S. Available
stuuies suggest that the main souice of high inflation of the peiiou was excessive money
supply giowth in a wai-iavageu economy (Bossain, 199S, 2uuu).
0n the economic fiont, theie was a mouest bieakthiough uuiing the miu-198us.
The economy staiteu to giow at a steauy pace of about 4.S peicent pei annum (Bossain,
199S, 1996). Bata foi the past few yeais show that the economy has moveu to an upwaiu
giowth path of about 6 peicent pei annum. Theiefoie the 198us anu the 199us iepiesent
a phase of moueiate inflation anu a ielatively high economic giowth.
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
3
With effect from May 31, 2003 Bangladesh entered a regime of floating exchange rate where the
exchange rate is determined through demand and supply of the currency
4
Source: Unpublished review on Monetary Policy, 2004.

7
0n the financial fiont, the Banglauesh Bank is iesponsible foi foimulation anu
implementation of the countiy's monetaiy policy. Accoiuing to the Banglauesh Bank
0iuei of 1972, the aim of monetaiy policy is "to suppoit highest sustainable output
along with ieasonable piice stability". The majoi instiuments that aie piesently useu
aie: Bank Rate, Cash Reseive Requiiement, Statutoiy Liquiuity Requiiement anu 0pen
Naiket 0peiation, anu Repo anu Reveise Repo 0peiation. Banglauesh Bank sets
taiget of giowth of bioau money (N2) keeping in view the expecteu giowth of ieal
income, peimissible iate of inflation anu the change in income velocity of money.
Buiing the peiiou of 197us anu 198us, the yeaily aveiage giowth iate of
bioau money was iecoiueu at 17.7u peicent anu 21.S9 peicent iespectively. This
steep iise in money supply was backeu by sectoial cieuit policy anu easy iefinances
facility of the monetaiy authoiity. Thioughout the 197us anu 198us, both selective
anu quantitative cieuit contiol measuies weie auopteu to pioviue auequate cieuit to
the state owneu enteipiises anu othei piioiity sectois to achieve the goveinment's
uevelopment objectives at the cost of inflation. Aveiage inflation in 197us was 16.76
peicent, which went uown to 1u.18 peicent in the 198us. Since the auoption of the
Financial Sectoi Refoim Piogiam in 199u, the policy stance shifteu towaiu inuiiect
contiol. The giowth of bioau money was to be maintaineu at levels consistent with
ieal output giowth anu stable, moueiate inflation using inuiiect monetaiy
instiuments. Noney supply iegisteieu a lowei yeaily aveiage giowth of 12.9u peicent
in the 199us. The yeaily aveiage inflation ueclineu to S.69 peicent uuiing the same
peiiou. Bowevei, bioau money giew at a compaiatively highei iate of 1S.11 peicent
uuiing 2uu1-2uuS. Inflation uiu not inciease uue to inciease in uBP. Buiing 2uu1-
2uuS, uBP incieaseu by S.u1 peicent compaieu to 4.81 peicent in the 199us. Aveiage
inflation fuithei ueclineu to S.u4 peicent.
A maiket baseu floating exchange iate system was intiouuceu in Banglauesh
fiom Nay S1, 2uuS. This is expecteu to biing aujustment of the exchange iate to
changing maiket anu economic conuitions. Piioi to its floatation, the Taka was peggeu
to a basket of haiu cuiiencies anu the exchange iate was aujusteu occasionally
uepenuing on the tienu of appieciation of the ieal exchange iate of Taka, oiiginating
fiom a ielatively high iate of inflation in Banglauesh vis--vis its tiauing paitneis. The
switch of the exchange iate iegime fiom the peggeu to a floating one took place in an
enviionment of balanceu economic funuamentals. The Taka iemaineu ielatively stable
aftei the float. Thus, uespite some concein, the tiansition tuineu out to be smooth.
The uealeis in the maiket have now aujusteu to the new enviionment. With the
floatation of the exchange iate, the monetaiy authoiities have gaineu gieatei contiol
ovei monetaiy instiuments.
Banglauesh is piacticing monetaiy taigeting since hei inuepenuence in 1972
unuei uiffeient exchange iate iegimes. Piioi to 199u, the policy was baseu on uiiect
contiol of vaiious instiuments, such as volume anu uiiection of cieuit anu inteiest
iates. Since the auoption of Financial Sectoi Refoim Piogiam in 199u, the policy
stance has shifteu towaiu inuiiect contiol.

8
0ntil 199u, the ueposit anu lenuing iates weie auministeieu inteiest iates.
Buiing that peiiou, inteiest iates weie ieviseu iaiely to aujust to inflation. Bowevei,
in oiuei to intiouuce maiket baseu inteiest iate system, a new inteiest iate policy
was put in place in eaily 199u. 0nuei this policy, banks weie alloweu to ueteimine
theii inteiest iates foi both ueposit anu lenuing. Initially Banglauesh Bank useu to
piesciibe the inteiest iate banus foi uiffeient categoiies of lenuing. Anu the banks
weie alloweu to move fieely within the banus. uiauually the inteiest iate banus foi
lenuing weie wiueneu anu ultimately withuiawn in Apiil 1992, except thiee piioiity
sectois (agiicultuie, expoit anu small anu cottage inuustiies). Inteiest iate banus foi
lenuing to agiicultuie anu small anu cottage inuustiies weie lifteu in August 1999.
Still theie is inteiest iate ceiling foi expoit loans. Floois on ueposits, weie in foice
until Febiuaiy 1996, theieaftei they weie withuiawn.
Though Cash Reseive Requiiements anuoi Statutoiy Liquiuity Requiiements
aie uiiect in natuie, these aie being useu as effective instiument fiom the beginning.
Banks weie iequiieu to maintain S peicent of theii total time anu uemanu ueposits as
cash ieseive iequiiement anu 2S peicent of time anu uemanu ueposits as statutoiy
liquiuity iatio until miu 198us. In1987, cash ieseive iequiiement was iaiseu to 1u
peicent anu continueu until 199u. Theieaftei piesciibeu liquiuity iatio of scheuuleu
banks was giauually ieuuceu to 2u peicent of which S peicent was the cash ieseive
iequiiement. The cash ieseive iequiiement was loweieu to 4 peicent in late 1999. In
view of injecting moie liquiuity in the economy, howevei, the liquiuity iatio was
fuithei ieuuceu to 16 peicent effective fiom Novembei 2uuS, leaving cash ieseive
iequiiement unchangeu at 4 peicent. Bowevei, in the face of upwaiu inflation in the
uomestic economy, the CRR was iaiseu to S peicent with effect fiom Naich u1, 2uuS
anu SLR fiom 16 peicent to 18 peicent on 0ctobei 1, 2uuS.
0pen maiket opeiation as policy instiument was not much effective until
199u. In 199u, Banglauesh Bank intiouuceu its own secuiity calleu "9u-Bay
Banglauesh Bank Bill". Latei "Su-Bay Banglauesh Bank Bill" was also intiouuceu in
199S. 0ntil 1997, Banglauesh Bank Bills weie bought anu solu thiough auctions as a
pait of its open maiket opeiation. The piocess of auction thiough maiket baseu
inteiest iates was also extenueu to goveinment tieasuiy bills fiom eaily 199us. In
1997, auction of Banglauesh Bank Bills was uiscontinueu anu goveinment tieasuiy
bills aie being useu as instiuments foi open maiket opeiation since then.
Repuichase Agieement (Repo) anu ieveise Repo weie intiouuceu foi banks
anu financial institutions as inuiiect monetaiy policy tools foi uay-to-uay liquiuity
management in iesponse to tempoiaiy anu unexpecteu uistuibances in the supply
anu uemanu foi money. Repo auction enables banks to place bius foi funus
collateializeu by tieasuiy bills. The Banglauesh Bank accepts the bius to the extent
neeueu to maintain the intenueu level of maiket liquiuity. Reveise Repo auction is the
counteipait of Repo auction, in which the banks submit offeis of theii excess funus,
which the Banglauesh Bank accepts to the extent neeueu to maintain the intenueu
level of liquiuity. The inflow of liquiuity with Repo opeiations helps in easing seasonal
volatility in the call money iate anu stabilize the money maiket. To encouiage anu
facilitate intei-bank Repo opeiations with same uay iecoiuing of the tiansfeis of
secuiities, steps, such as the intiouuction of piimaiy uealeiship system, weie taken to
activate the seconuaiy maiket foi goveinment tieasuiy billsbonus. To establish a

9
high-tech stanuaiu tiansaction mechanism foi vaiious goveinment billsbonus in
piimaiy anu seconuaiy maikets, an on-line system has been put in place since
0ctobei 2u, 2uuS.
Monetary!Policy!in!India!
Like othei ueveloping countiies, the bioau objectives of monetaiy policy in
Inuia aie to maintain a ieasonable uegiee of piice stability anu to help to acceleiate
the iate of economic giowth. The ielative emphasis placeu on piice stability anu
economic giowth is changeu accoiuing to the ciicumstances pievailing at a paiticulai
point in time, claiifieu fiom time to time in the policy statements of the Reseive Bank
(Reuuy, 2uu7). The monetaiy anu cieuit policy is the policy statement tiauitionally
announceu twice a yeai. Theie aie foui main channels which the Reseive Bank of
Inuia looks at: (a) quantum channel: money supply anu cieuit (affects ieal output anu
piice level thiough changes in ieseive money, money supply anu cieuit aggiegates)
(b) inteiest iate channel (c) exchange iate channel anu (u) asset piice channel.
The Inuian economy has emeigeu as a high-giowth economy with the aveiage
giowth iate of 8.6 peicent pei annum uuiing FYuS to FYu7 wheie in the last two yeais
the giowth iate has aveiageu 9.1 peicent. The aveiage giowth iate of the Inuian
economy ovei a peiiou of 2S yeais since FY81 (Inuia's fiscal yeai is fiom 1 Apiil to S1
Naich) has been about 6.u peicent, which is a significant impiovement ovei the
annual giowth iate of S.S pei cent ovei the pievious thiee uecaues of FYS1 to FY8u
(Reuuy, 2uu7). Nacioeconomic anu financial stability togethei with uomestic
consumption, investment anu expoit uemanu aie also contiibuting factois behinu
highei giowth in Inuia. The stiengthening of economic activity has been suppoiteu by
peisistent inciease in uomestic investment iate fiom 22.9 pei cent of uBP in 2uu1-u2
to SS.8 pei cent in 2uuS-u6 coupleu with an efficient use of capital. Bomestic saving
iate has also impioveu fiom 2S.S pei cent to S2.4 pei cent uuiing the same peiiou uue
to impiovements in both public anu piivate coipoiate saving (Annual Repoit, RBI,
FYu7).
Buiing last one anu a half yeai, the Inuian economy has also gone thiough a lot
of changes. Among the changes, incieasing openness of the Inuian economy plays an
impoitant iole in achieving highei giowth. Buiing this peiiou, Inuia's economic
ielationship with the iest of Asia was built up thiough sustaineu expansion in tiaue
anu financial ielationships. The shaie of expoits to ueveloping Asia in Inuia's total
expoits moie than uoubleu fiom 14 pei cent in 199u-91 to almost Su pei cent in
2uuS-u6. The coiiesponuing shaie of the iegion in Inuia's impoits also incieaseu fiom
14 pei cent to 21 pei cent uuiing this peiiou (Nohan 2uu6).
Nonetaiy policy fiamewoik has also gone thiough a lot of significant changes.
Foi example, the bioau money (NS) was useu as the nominal anchoi fiom the miu-
198us baseu on the assumption of a stable ielationship between money, output anu
piices which was changeu in the late 199us uue to ongoing financial openness
togethei with incieasing eviuence of changes in unueilying tiansmission mechanism.

10
The Reseive Bank, foimally auopteu a multiple inuicatoi appioach in Apiil 1998
wheie inteiest iates oi iates of ietuin in uiffeient financial maikets along with uata
on cuiiency, cieuit, tiaue, capital flows, fiscal position, inflation, exchange iate, etc.,
aie put siue by siue with the output uata foi uiawing policy peispectives (Reuuy,
2uu7). Such a shift implementeu giauually ovei the iefoim peiiou since the eaily
199us enableu the economy to gain iequiieu flexibility to iesponu to changes in
uomestic anu inteinational economic enviionment anu financial maiket conuitions
moie effectively.
In the changing piocess, ieliance on uiiect instiuments was ieuuceu
gieatly anu a policy piefeience foi inuiiect instiuments became the basis of
monetaiy policy opeiations. In so uoing, the Reseive Bank puisues, inter!alia,!a
policy of active liquiuity management thiough open maiket opeiations (0N0)
anu uaily ieveise iepo anu iepo opeiations unuei a Liquiuity Aujustment
Facility (LAF), Naiket Stabilization Scheme (NSS) anu cash ieseive iatio
(CRR), anu uses the mix policy instiuments flexibly as necessaiy foi the
situation. Bowevei, the tiauitional emphasis on the use of bioau money as an
inteimeuiate taiget has been ue-emphasizeu although the giowth in bioau money
(NS) continues to be useu as impoitant inuicatois. Since 1998-1999, the Reseive
Bank of Inuia has been auopting a multiple inuicatois appioach in its monetaiy policy.
Some of the impoitant changes in monetaiy policy fiamewoik anu opeiating
pioceuuies in Inuia uuiing the 199us incluue ue-linking of buuget ueficit fiom its
automatic monetization by the Reseive Bank, ueiegulation of inteiest iates, anu
uevelopment of the financial maikets with ieuuceu segmentation thiough bettei
linkages anu uevelopment of appiopiiate tiauing, payments anu settlement systems
along with technological infiastiuctuie (Reuuy, 2uu7). In auuition, impioveu
monetaiy anu fiscal cooiuination helpeu inflation outcome to come uown significantly
uuiing the seconu half of the 199us.The inflation iate ueclineu fiom an aveiage of 11.u
pei cent uuiing 199u-9S to S.S pei cent uuiing the seconu half of the 199us. Lately,
uespite sustaineu exteinal capital inflows anu continueu suige in fuel anu foou piices
in the uomestic anu exteinal maiket uuiing 2uuS-u6, the aveiage heauline inflation
iate iemaineu at about 4.S peicent anu inflation expectations iemaineu well
containeu uespite continueu uominance of auveise supply-siue factois uue mainly to
moie focuseu macioeconomic anu monetaiy management anu incieasing tiaue
openness. The heauline inflation, as measuieu by the Wholesale Piice Inuex (WPI),
was S.S peicent uuiing }anuaiy-Naich 2uu8, which was 6.7 peicent uuiing the same
peiiou pieceuing yeai.


11
This stuuy examines the impact of monetaiy shocks on Banglauesh. In uoing
so, we examineu the impacts of both uomestic anu foieign monetaiy policy on
Banglauesh's economic aggiegates. Because Banglauesh Bank uses N2 as an
inteimeuiate taiget, we use N2 as oui measuie of monetaiy policy shocks. Foi
puiposes of compaiison, we use Inuia's N2 as oui measuie of foieign monetaiy
shocks. We examine the impact of uomestic anu foieign monetaiy shocks on uomestic
output (inuustiial piouuction), the piice level (CPI), inteiest iate (lenuing iate), anu
the ieal exchange iate. Inuia's money supply is useu as a measuie of foieign monetaiy
policy.
S

V. Methodology,!Estimation,!and!Empirical!Results!
A neai vectoi autoiegiessive (NvAR) mouel is an appiopiiate econometiic
technique when we aie inteiesteu in uynamic ielationships among vaiiables in
piesence of uiffeient explanatoiy vaiiables (Enueis, 199S). Baseu on the assumption
that Inuia is a laige countiy ielative to Banglauesh, NvAR is estimateu. The NvAR
contains five vaiiables fiom Banglauesh anu one vaiiable fiom Inuia. The five
equations foi the Banglauesh vaiiables aie stanuaiu vAR equations. That is, in these
equations, all mouel vaiiables entei each equation. Because Inuia is assumeu to be a
laige countiy ielative to Banglauesh, the equation foi NI contains laggeu values of NI
only. Banglauesh vaiiables aie not alloweu to have an impact on Inuia's money
supply.
6


The NvAR is useu to ueiive vBCs. The vBCs show the poition of the foiecast
eiioi vaiiance in each vaiiable uue to innovations to all system vaiiables. 0ui concein
is with the poition of foiecast eiioi vaiiance in LR, CPI, Y, anu RER explaineu by the
change in Inuia's monetaiy (NI) anu Banglauesh's monetaiy policy (NB). If NI
explains a significant poition of the foiecast eiioi vaiiance in uomestic vaiiables, then
foieign money has a significant impact on the uomestic economy. If NB explains a
significant poition of the foiecast eiioi vaiiance in uomestic vaiiables, then uomestic
money has a significant impact on the uomestic economy.
Akaike's AIC is useu to ueteimine the optimal lag length foi the NvAR; the
maximum lag length examineu is eight quaiteis. As Enueis (199S) notes, in the case
of an NvAR, seemingly unielateu iegiession (S0R) estimation pioviues efficient
estimates. Bence, oui mouel is estimateu with iteiative S0R. The AIC ieaches a
minimum at lag eight. Q-statistics pioviue eviuence that lag 8 is auequate; Q-statistics
inuicate that the iesiuuals fiom each NvAR equation aie white noise.
7

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
5
Indias economy is large relative to Bangladeshs, and Bangladesh shares most of its
border with India. Hence, we examine the impact of Indias money supply on Bangladeshs money
supply. We also examine the impact of Indias money supply on the real exchange rate and
Bangladeshs money supply, interest rate, price level, and output.
6
A series of Granger-causality tests confirms that Bangladesh variables do not have
significant impacts on the Indian money supply.
7
With one exception, major policy implications are unchanged when the NVAR lag length is
arbitrarily set at four. When the lag length is set at 8, as the AIC suggests, the VDCs indicate that
shocks to MI explain a significant portion of the forecast error variance in Y. When the NVAR lag

12
To estimate vBCs, oithogonal iesiuuals aie iequiieu. We use a Cholesky
uecomposition to oithogonalize the iesiuuals. A Cholesky uecomposition iequiies the
vaiiables to be oiueieu in a paiticulai way. Bue to cioss-equation iesiuual coiielation,
when a vaiiable highei in the oiueiing changes, all the vaiiables lowei in the oiueiing
aie assumeu to change. That is, vaiiables placeu highei in the oiueiing aie assumeu
to have a contempoianeous impact on vaiiables lowei in the oiueiing. vaiiables
lowei in the oiueiing uo not have a contempoianeous impact on vaiiables highei in
the oiueiing.
The Cholesky oiueiing useu in this papei is: NI, RER, NB, LR, CPI, Y.
8
This
oiueiing implies that the NI innovation is contempoianeously exogenous. NI has a
contempoianeous effect on othei mouel vaiiables, but the othei mouel vaiiables have
no contempoianeous impact on NI. This is consistent with the assumption that Inuia
is a laige countiy ielative to Banglauesh. The exchange iate is placeu seconu in the
oiueiing because, in a small open economy, a shock to foieign money will tiansmit to
the uomestic economy thiough the exchange iate. NB is the Banglauesh Bank's policy
vaiiable. Because of this, NB is placeu thiiu in the oiueiing. The simple Keynesian
view of monetaiy policy inuicates that shocks to the money supply aie tiansmitteu to
piices anu output thiough the inteiest iate. Bence, we place the lenuing iate (LR)
above the CPI anu Y in the oiueiing.
9
We assume that piices aie sticky with iespect to
changes in outputat least in the cuiient peiiou. Because of this, we place CPI above
Y in the oiueiing. This allows changes in the piice level to have a contempoianeous
impact on output. Bowevei, output uoes not have a contempoianeous impact on the
piice level.
Model!Variables!
Banglauesh switcheu fiom a fixeu exchange iate to a floating exchange iate iegime in
Nay 2uuS. Because of this, oui sample peiiou coveis 1976:1 to 2uu2:4; quaiteily
uata.
1u
To examine the uynamic ielationships among foieign money, uomestic money,
the exchange iate, the inteiest iate, the piice level anu output, a six-vaiiable NvAR
mouel is estimateu.
11
The vaiiables useu in the mouel aie:
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
length is reduced to 4, shocks to MI do not explain a significant portion of the forecast error variance
in Y. In is important to note that when the NVAR lag length is reduced to 4, the NVARs Y
equation does not produce white noise errors.
8
The model has also been estimated where RER and MB are switched in the ordering. Policy
conclusions are unchanged with this change in the ordering.
9
Efficient market arguments would place LR last in the ordering. Policy conclusions are unchanged
by this change in the ordering.


10
Extending the estimation period to 2006:2 produces similar results to those obtained from the
sample period that ends in 2002:4. This result is not surprising. Bangladesh devalued its currency
approximately 120 times between 1972 and 2001. In some sense, Bangladesh did not have a fixed
exchange rate regime prior to May 2003.
11
Following Bernanke, Gertler, and Watson (1997), Cushman and Zha (1997), McMillin (1996), and
Sims (1992), we have chosen to estimate our NVAR with the variables in levels (LR) and log levels

13

NI=log of Inuia's ieal money supply (N2);
NB= log of Banglauesh's ieal money supply (N2);
12

LR= Banglauesh's lenuing iate on commeicial bank loans;
CPI=log of Banglauesh's consumei piice inuex;
1S

Y= log of Banglauesh's ieal output measuieu by inuustiial piouuction.
RER= log of ieal exchange iate.
14

Seasonally aujusteu uata aie useu foi all the vaiiables with the exception of inteiest
iate. A uesciiption of the vaiiables is given in uetail in the uata appenuix.
1S

Empirical!Results!
The empiiical iesults aie containeu in the vBCs which aie iepoiteu in Table 2.
The estimates of the foiecast eiioi vaiiance aie consiueieu significant if the point
estimate is at least two times as laige as its stanuaiu eiioi. Five thousanu bootstiap
simulations aie useu to constiuct the stanuaiu eiiois. Because NI is assumeu to have
exogenous influence on Banglauesh, we iepoit the vBCs foi Banglauesh vaiiables
only.
The iesults in Table 2 show that shocks to NI have significant impacts on the
ieal exchange iate (RER), the uomestic money supply, anu output. At longei time
hoiizons, shocks to NI explain ovei 4S pei cent of the foiecast eiioi vaiiance in both
LR anu Y. Bence, shocks to NI have significant impacts on Banglauesh's uomestic
economy.
The iesults in Table 2 also show that innovations to NI explain significant
poitions of the foiecast eiioi vaiiance in RER at all time hoiizons. In fact, innovations
to NI explain ovei 8S pei cent of the foiecast eiioi vaiiance in RER at each time
hoiizon, while innovations in NB explain less than 4 pei cent of the foiecast eiioi
vaiiance in RER at each time hoiizon.
Fuithei analysis of Table 2 shows that innovations to NI explain significant poitions
of the foiecast eiioi vaiiance in LR anu Y. At longei time hoiizons, innovations to NI
explain almost Su pei cent of the foiecast eiioi vaiiance in LR, while innovations to
NB explain at most 1S.4 pei cent of the foiecast eiioi vaiiance in LR. This iesult has
impoitant implications foi monetaiy policy in Banglauesh. Shocks to Inuia's money
supply have much laigei impacts on inteiest iates in Banglauesh than uo shocks to
Banglauesh's own money supply.
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
(MI, MB, CPI, Y, RER). Sims, Stock, and Watson (1990) discuss the appropriateness of estimating
models in levels.
12
A model has also been estimated with M1 in place of M2 for both India and Bangladesh. Policy
implications with respect to the impact on MI and MB on other model variables are unchanged when
M1 is used in place of M2.
13
Data on the wholesale price index for Bangladesh is available on annual basis only.
14
We use the real exchange rate as a channel through which foreign monetary policy transmits to the
domestic economy. Adding a trade volume variable to the model might also be useful.
15
A fiscal variable, such as the government budget deficit, might also be an informative model
variable. However, quarterly data on the government budget deficit are not available.


14
Table!2!!
Variance!Decomposition!of!Bangladesh!Variables!
!
Real!Exchange!Rate!(RER)!!
!
Horizon MI RER MB LR CPI Y
4 85.2*
(4.5)
11.8
(3.3)*
0.7
(0.7)
1.7
(1.0)
0.2
(0.4)
0.3
(0.5)
8 88.3*
(4.5)
6.7
(2.4)*
2.7
(1.6)
1.7
(1.0)
0.4
(0.5)
0.2
(0.4)
12 87.1*
(5.8)
5.3
(2.2)
3.1
(1.9)
2.7
(1.6)
1.2
(1.0)
0.7
(0.7)
16 87.0*
(6.2)
5.1
(2.2)
3.1
(2.0)
2.8
(1.8)
1.2
(1.1)
0.8
(0.9)

Real Money (MB)
Horizon MI RER MB LR CPI Y
4 8.7
(15.6)
2.1
(4.1)
83.4
(14.8)*
0.7
(2.2)
3.3
(3.5)
1.8
(3.3)
8 6.0
(15.5)
3.9
(5.3)
71.6
(14.2)*
0.6
(4.2)
11.9
(6.6)
5.9
(5.7)
12 13.6
(17.2)
5.9
(5.2)
60.1
(13.5)*
0.5
(4.8)
10.8
(5.5)
9.1
(5.7)
16 24.2
(19.1)
5.3
(4.7)
48.1
(12.9)*
0.6
(4.8)
8.9
(5.1)
12.9
(5.7)*

Lending Rate (LR)

Horizon MI RER MB LR CPI Y
4 4.9
(12.5)
3.0
(4.4)
3.1
(5.0)
76.5
(13.8)*
10.8
(8.0)
1.7
(3.1)
8 43.5
(19.1)*
1.6
(3.3)
2.8
(3.6)
43.7
(14.0)*
7.1
(4.8)
1.3
(2.8)
12 48.0
(18.9)*
1.8
(3.6)
7.2
(4.9)
34.1
(12.1)*
6.8(
4.3)
2.1
(3.3)
16 47.3
(18.5)*
1.5
(3.5)
13.4
(6.7)*
27.0
(10.7)*
8.7
(4.5)
2.1
(3.2)

! !

15
Price!Level!(CPI)!
Boiizon NI RER NB LR CPI Y
4 2.6
(1u.4)
14.1
(7.2)
S2.1
(1u.S)*
1u.2
(7.2)
S9.6
(9.S)*
1.S
(2.4)
8 2.6
(1S.8)
9.9
(S.9)
S1.u
(9.7)*
1u.8
(6.9)
4S.6
(1u.S)*
2.u
(S.S)
12 7.6
(16.7)
8.9
(S.S)
29.8
(8.9)*
1u.7
(6.2)
4u.S
(9.6)*
2.4
(S.4)
16 16.7
(18.2)
7.9
(4.8)
26.u
(8.u)*
1u.4
(S.8)
S6.7
(8.9)*
2.2
(S.1)
!
Output!(Y)!

Boiizon NI RER NB LR CPI Y
4 16.4
(1S.S)
S.9
(4.S)
1S.S
(7.8)
S.u
(S.8)
6.6
(4.S)
S4.7
(11.S)*
8 SS.1
(1S.S)*
S.6
(S.8)
12.7
(6.S)*
1.9
(2.9)
S.1
(S.S)
41.6
(9.2)*
12 4S.S
(16.u)*
6.S
(S.8)
1u.4
(6.u)
1.S
(2.7)
S.S
(S.S)
S1.2
(8.2)*

16 S6.S
(16.2)*
S.S
(S.6)
7.S
(S.S)
1.6
(2.8)
4.4
(S.1)
24.9
(7.9)*



Note: The entiy in each cell iepiesents the point estimate foi the peicentage of the foiecast
eiioi vaiiance in a given Banglauesh vaiiable explaineu by innovations to the inuicateu
vaiiable. Stanuaiu eiiois aie in paientheses. Point estimates aie consiueieu significant if
they aie twice as laige as the stanuaiu eiioi. * inuicates significance of the point estimate.

The lowei poition of Table 2 shows vBCs foi output in Banglauesh. These
vBCs show that, at longei time hoiizons, innovations to NI explain ovei aiounu Su pei
cent of the foiecast eiioi vaiiance in Y. In contiact, innovations to NB explain at most
1S.S pei cent of the foiecast eiioi vaiiance in Y.
Table 2 also ieveals that innovations to NB explain significant poitions of the
foiecast eiioi vaiiance in Banglauesh's CPI anu NB itself. The shocks to NB aie
paiticulaily impoitant in explaining the foiecast eiioi vaiiance in CPI. Regaiuless of
the time hoiizon, shocks to NB explain ovei 2S pei cent of the foiecast eiioi vaiiance
in CPI. This amount is significant at each time hoiizon.
Shocks to NB also explain ovei 2S pei cent of the foiecast eiioi vaiiance in
NB at each time hoiizon. It is inteiesting to note that, although shocks to NI explain

16
significant poitions of the foiecast eiioi vaiiance in LR at each time hoiizon, shocks to
NI nevei explain significant poitions of the foiecast eiioi vaiiance in NB.
16
That is,
shocks to Inuia's money supply have significant impacts on Banglauesh's inteiest iate,
but not Banglauesh's money supply.

VI. Conclusions!
In this papei, we have examineu the impact of monetaiy shocks on economic
aggiegates in Banglauesh. Specifically, the impact of monetaiy shocks in alteiing key
macioeconomic vaiiables such as the inteiest iate, piice level, exchange iate anu
output was examineu. Since the impact of both uomestic monetaiy shocks anu foieign
monetaiy shocks was examineu, the Inuian money supply was useu as the measuie of
foieign monetaiy shocks.
0ui iesults inuicate that uomestic (NB) monetaiy shocks have significant impacts
on uomestic vaiiables. Peihaps moie impoitantly, oui iesults inuicate that shocks to
NB have significant impacts on uomestic piice level (CPI) anu uomestic income (Y). 0ui
iesults also show that shocks to NB have significant impacts on LR at longei time
hoiizons. 0ui iesults also show that shocks to NB have significant impact on CPI. This
is not the case of NI. Shocks to NI uo not appeai to have an influence on CPI.
The iesults also show that shocks to Inuian money supply (NI) have impoitant
impact on Banglauesh's uomestic vaiiables. Specifically, shocks to NI have significant
impacts on the ieal exchange iate (RER). In this papei, we useu TakaRupee exchange
iate which woiks in favoi of Inuia which incieaseu Inuia's expoit to Banglauesh. The
vBCs show that shocks to NI have laigei impacts on Y than shocks to NB which also
make sense uue to highei uegiee of integiation in teims of goous anu seivices anu
cioss boiuei effect anu favoiable exchange iate policy of Inuia.
The iesults aie not suipiising in the context of an integiateu woilu economy.
In this iegaiu, the iesults of the stuuy by 0zuemii (2uu8) may be citeu which
concluue that the inuiiect effects oiiginating fiom a tiaue paitnei aie founu to have
significant impact on a small open economy moie than equal sizeu shocks coming
fiom non-paitnei countiies. The paitnei countiy's inuiiect effect is founu to be
mitigateu by paiticipating in a monetaiy policy cooiuination iegime. Theiefoie, in
oiuei to avoiu contagion effect oiiginating fiom tiaue paitnei countiies, Banglauesh
shoulu stait peisuauing cooiuinateu monetaiy policy.

!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
16
At the 16 quarter time horizon, the point estimate for the amount of the forecast error variance in
MB explained by shocks to MI approaches 25 per cent. However, due to the large standard error,
this point estimate is not considered significant.

17
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19
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Data!Appendix!
Description!of!Variables!

CPI is the log of Banglauesh's uomestic consumei piice inuex (2uuu=1uu); the cost of
living inuex of Bhaka miuule income families. The seasonally unaujusteu uata on CPI
aie seasonally aujusteu using the X11 pioceuuie in SAS. 0naujusteu quaiteily uata on
consumei piice inuex aie available fiom Economic Tienus, a Banglauesh Bank
publication.

CPI_I is the log of foieign (Inuia) consumei piice inuex (2uuu=1uu); the cost of living
inuex foi the inuustiial woikeis of seventy inuustiial centeis in Inuia. Seasonally
unaujusteu uata on CPI_I aie seasonally aujusteu using the X11 pioceuuie in SAS.
0naujusteu quaiteily uata on CPI_I aie available fiom Inteinational Financial
Statistics (IFS) CB-R0N.

NB is the log of Banglauesh's seasonally aujusteu ieal money supply (N2) in Cioie
Taka. Seasonally unaujusteu uata on nominal N2 anu CPI aie seasonally aujusteu
using the X11 pioceuuie in SAS. The seasonally aujusteu money supply is uiviueu by
the seasonally aujusteu CPI to get the seasonally aujusteu ieal money supply.
0naujusteu quaiteily uata on N2 aie available fiom Economic Tienus.

NI is the log of Inuia's ieal money supply (in Cioie Taka). Inuia's N2 is seasonally
aujusteu using the X11 pioceuuie in SAS. The uata on Inuia's money supply weie
initially in national cuiiency (Billions of Rupee). To place Inuia's money supply

in
uomestic monetaiy teims, the uata on Inuia's money supply was tiansfoimeu into
cioie taka by uiviuing by TakaRupee nominal exchange iate. The ieal money supply
is the nominal money supply

uiviueu by CPI_I. Quaiteily uata on Inuia's money supply
fiom the IFS CB-R0N.

RER is the log of ieal exchange iate (TKR0). RER is calculateu by multiplying the
unaujusteu nominal exchange iate by the iatio of CPI_I anu CPI. Bata on the nominal
exchange iate is available fiom the IFS CB-R0N.

Y is the log of ieal output (2uuu=1uu). 0naujusteu uata on inuustiial piouuction aie
seasonally aujusteu using the X11 pioceuuie in SAS. 0naujusteu quaiteily uata on
inuustiial piouuction aie available fiom the IFS CB-R0N.

LR is the commeicial bank lenuing iate on inuiviuual anu business loans. The uata on
lenuing iates aie available fiom the IFS CB-R0N.
!