University of Dhaka

A Report on

“Inflation:

Perspective Bangladesh”

Date of Submission: May 26, 2011

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A Report on

“Inflation: Perspective Bangladesh”

Course no. & name: F-203-Macroeconomics

Submitted to:

Mohammad Salahuddin Chowdhury

Lecturer

Department of Finance

University of Dhaka

Submitted by:

Group: Morning Stars

Sec-B

BBA 16th batch

Dept. of Finance

University of Dhaka

Date of Submission: May 26, 2011

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Group members are

Name Roll

K. M. Najmus Sakib 16-020

Mobasheera Tasnim 16-052

Md. Kamrul Islam 16-090

Rajib Kumar Deb 16-106

Shaykha Sultana 16-160

Md. Shamsul Alam 16-172

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Letter of TransmittalMay 26, 2011

Mohammad Salahuddin ChowdhuryLecturerDepartment of Finance University of Dhaka

Subject: Submission of a report on “Inflation: Perspective Bangladesh”

Dear Sir,

We are presenting a report on “Inflation: Perspective Bangladesh”. In this report we have included various methodologies to explain the current scenario of inflation in Bangladesh. In making the study, we had to take help from the various sources of internet, different institutes and class lectures of our course teacher. We are grateful to them for extending generous help.

We acknowledge the contribution of our course teacher heartily. We have tried to use our academic knowledge in real life.

We are pleased to be granted this vital opportunity and grateful for your versatile assistance. We hope that our work will please you. We will be available in the presentation for further explanations.

Sincerely,

__________________

Mobasheera Tasnim

On behalf of The Group

Morning Stars

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Acknowledgements

First of all I offer my grateful thanks to the Almighty, without whose blessings this report wouldn’t have been possible.

I sincerely thank the instructor of our Macroeconomics course, Mohammad Salahuddin Chowdhury for his earnest help and thoughtful insight in preparing this report.

I would thank my group members for their kind help and assistance in preparing this report.

My heartiest gratitude to Mr. Debashish Roy at Bangladesh Bank, Ms. Syeda Anoara Begum at Ministry of Finance and Ms. Rebeka Amin at Bangladesh Bureau of Statistics for their help in preparing this report.

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List of Acronyms

AS- Aggregate Supply FY- Fiscal year CPI- Consumer Price Index BB- Bangladesh Bank GDP- Gross Domestic Product BBS- Bangladesh Bureau of Statistics IMF- International Monetary Fund CIA- Central intelligence Agency ADB- Asian Development Bank TCB- Trading Corporation of Bangladesh

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Table of Contents

Acknowledgements

List of Acronyms

Executive Summary

1.0 Introduction 12-14

1.1 Origin of the Report 12

1.2 Problem and Objectives 12

1.2.1 Problem Statement 12

1.2.2 Objectives of the Report 12

1.2.2.1 Primary Objectives 12

1.2.2.2 Secondary Objectives 12

1.3 Scope of the Report 12

1.4 Limitations of the Report 13

1.5 Background of the Report 13

1.6 Methodology of the Report 13

1.6.1 Primary Data 13

1.6.2 Secondary Data 13

1.7 Report Preview 14

2.0 Literature Review 15-27

2.1 Inflation 15

2.2 Components of Inflation 15

2.3 Measures 16

2.4 History of Inflation 16

2.5 Types of Inflation 17

2.6 Causes of Inflation 20

2.7 Disinflation 22

2.8 Disinflation & Sacrifice Ratio 22

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2.9 Rational expectation & possibility of painless disinflation 23

2.10 Effects of Inflation 23

2.11 Controlling Inflation 26

3.0 Current Situation of Inflation in Bangladesh 28-333.1 Bangladesh Economic Review & Bangladesh Bureau of Statistics 283.2 International Monetary Fund 313.3 CIA World Factbook 33

4.0 Causes of Inflation in Bangladesh 34-40

5.0 Effects of Inflation in Bangladesh 41-42

6.0 Policy Options 43-44

7.0 Conclusion 45

8.0 References 46

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List of Illustrations

List of Tables

Table No. Table Name Page No.

01 Rate of Inflation (National) 28

02 Monthly Rate of Inflation (Point- to- Point) during FY 2009-10 30

03 Year-wise inflation rate & percent change 32

04 Year-wise percent change in inflation rate 33

05 Money supply in Jul’08 38

06 Money supply in Jul’09 38

07 Money supply in Jul’10 38

08 Inflow of Remittance 40

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List of Figures

Fig. no. Figure Name Page no.

01 Cost-push inflation 18

02 Demand-pull inflation 19

03 Phillips Curve 21

04 National rate of Food & Non-food inflation 29

05 Year-wise chart of Inflation 31

06 Year-wise bar chart of Inflation Rate 33

07 Price of Rice (2001-2011) 34

08 Price of Wheat (2001-2011) 35

09 Price of Soya (2001-2011) 35

10 Price of Sugar (2001-2011) 36

11 Price of Diesel (2006-11) 36

12 Bangladeshi Taka & Indian Rupee Exchange Rate (Apr’10-Apr’11) 37

13 Transmission Mechanism of Reserve Accumulation 39

14 Projected Food & Non-food Inflation Rate 41

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Executive SummaryThis report was about analyzing current situation of inflation in Bangladesh. Here we showed the data of current inflation rate of Bangladesh. Then we tried to find out what are the vital reasons working behind the recent upraise in inflation rate and how it is affecting our economy as a whole & the people. At the end we recommended some policy options to curb this rising inflation rate.

We have found that there are number of factors behind the rising trend of inflation in Bangladesh. The factors contributed the most in the rise hike of essential items, particularly food, are slow growth in agriculture, rise in the world prices of food items, sharp depreciation of taka against US dollar and especially against the Indian rupee, and rise in the prices of diesel and kerosene.

These causes affect our general people directly. As per capita GDP is not responding with inflation, purchasing power of people has shrunk drastically. Food inflation is causing more problems for rural people than urban people. And loss of Taka’s value is making people go down class hierarchy.

We recommend that Bangladesh Bank should take necessary steps to reduce inflation rate. We have to be concerned about devaluation of our currency.

Inflation is a complex, dynamic process which cannot be comprehended simply through occasional debates or newspaper articles. Rigorous research is needed to understand inflation dynamics and its implications for monetary policy. Much of the responsibilities lay within the purview of local universities, policy institutes, and in particular the Bangladesh Bank.

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1.0 Introduction:

1.1 Origin of the Report:

Formal business report writing is a mandatory requirement of the Business Communication course of the BBA program. This report was assigned to give the students a better understanding of their studied theories and real life application of it.

As inflation is one of the most important macroeconomic phenomenons it is very important to know how it affects our national economy. That’s why this report was assigned to understand the current situation of inflation in Bangladesh perspective.

1.2 Problem & Objectives:

1.2.1 Problem Statement:

A report on “Inflation: Perspective Bangladesh”.

1.2.2 Objectives of the Report:

1.2.2.1 Primary Objectives:

The primary objective of the report is to fulfill the requirement of the Macroeconomics course of the BBA Program.

1.2.2.2 Secondary Objectives:

The secondary objective of the report is to analyze the condition of inflation in Bangladesh.

1.3 Scope of the Report:

This report analyses the impact of current upraise in the rate of inflation in

Bangladesh.

This report recommends some policies to control the rate of inflation.

This report doesn’t compare the inflation situation of Bangladesh with

other countries.

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1.4 Limitations of the Report:

Research work is very much comprehensive. It is an accumulation of both

information and creative thinking. It requires a great effort and long sound

planning to make a report. It is true that we got help from many highly

qualified people. But still we faced some problem. As we are really new in this

field and it is our first report in our life; we felt lack of experience in every

stage of our work. And there was not enough time for this project. But we

tried our level best to overcome this. On top of that our topic was about

Analysis of Inflation Scenario in Bangladesh Perspective; which was a very

complex topic. In this respect there may be some lacking in the report

because of our knowledge limitation. We tried to present the data available

accurately. Still there might be some problems with the presented data & our

interpretation. But all these errors are totally unintentional. At the end we are

very happy to present this report to the readers and its success will depend on

the positive response of the readers.

1.5 Background of the Report:

Inflation of is one of the most vital factors of our economy. So this report was

assigned to us to analyze the causes & effects of the current inflation situation

in Bangladesh.

1.6 Methodology:

1.6.1 Primary Data:

No primary data was collected to prepare this report.

1.6.2 Secondary Data:

Secondary data from different sources were gathered to prepare this report.

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1.7 Report Preview:

This report is prepared to analyze the impact of inflation in the economy of Bangladesh. We gathered information about CPI & Inflation rate in Bangladesh.

Then we tried to find out the causes behind it & how it affected the economy and the citizens of Bangladesh.

At the recommended some policies, if taken, should curb the current upraise in the inflation rate.

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2.0 Literature Review:

2.1 Inflation:

Inflation is an increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.

This definition includes some of the basic economics of inflation and would seem to indicate that inflation is not defined as the increase in prices but as the increase in the supply of money that causes the increase in prices i.e. inflation is a cause rather than an effect.

Inflation's effects on an economy are various and can be simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation may discourage investment and savings, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring central banks can adjust nominal interest rates (intended to mitigate recessions), and encouraging investment in non-monetary capital projects. Today, most mainstream economists favor a low, steady rate of inflation.

The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

2.2 Components of inflation:

Inflation=Expected inflation-β(U-U*) +V

Here,

β =Sensitivity

U*=Natural rate of unemployment

U=Unemployment

V=Supply shocks

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Policy maker do not have any influence over Supply shock & expected rate of inflation. So, they try to manage inflation by controlling unemployment rate.

2.3 Measures:

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time.

For instance, in January 2010, the Bangladesh Consumer Price Index was 324.21, and in January 2011 it was 350.54. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2010 is:

(350.54-324.21)/324.21=0.103 or 10.3%

The resulting inflation rate for the CPI in this one year period is 10.3%, meaning the general level of prices for typical Bangladeshi consumers rose by 10.3% in 2010.

2.4 History of Inflation:

Inflation has occurred in many different societies throughout history, changing with different forms of money used. From the second half of the 15th century to the first half of the 17th, Western Europe experienced a major inflationary cycle referred to as the "Price Revolution “with prices on average rising perhaps six fold over 150 years. This was largely caused by the sudden influx of gold and silver from the New World into Habsburg Spain The silver spread throughout previous cash starved Europe, and caused widespread inflation. Demographic factors also contributed to upward pressure on prices, with European population growth after depopulation caused by the Black Death pandemic.

By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in the commodity price of the metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their

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redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods

This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume & David Ricardo, who would go on to examine and debate to what effect a currency devaluation (later termed Monetary Inflation) has on the price of goods (later termed price inflation, and eventually just inflation).

The adoption of fiat currency (paper money) by many countries, from the 18th century onwards, made much larger variations in the supply of money possible. Since then, huge increases in the supply of paper money have taken place in a number of countries, producing hyper inflations-- episodes of extreme inflation rates much higher than those observed in earlier periods of commodity money. The hyper inflation suffered by the Weimar Republic of Germany is a notable example.

2.5 Types of inflation:

There are two major types of inflation:

1. Cost-push inflation: This is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil can create cost-pull inflation. It is also called “Supply shock inflation”. Because it is caused by adverse supply shock.Example: if Production Costs increases, a company may need to increases wages if laborers demand higher salaries (due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that can cause increases in production costs is a rise in the price of raw materials. It happened because of scarcity of raw materials.

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Fig 01: Cost-push inflation

Putting It Together:To visualize how cost-push inflation works, we can use a simple price-quantity graph showing what happens to shifts in aggregate supply. The graph aboveshows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation. Cost-push inflation cause inflationary recession.

2. Demand-pull inflation: The rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that increases aggregate demand can cause inflation.Example: an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners.

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Fig 02: Demand-pull inflation

Putting It Together

Demand-pull inflation is a product of an increase in aggregate demand that is faster than the corresponding increase in aggregate supply. When aggregate demand increases without a change in aggregate supply, the ‘quantity supplied’ will increase (given production is not at full capacity). Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply. As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P1 to P2. The rationale behind this change is that companies would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production.There is also a kind of inflation which is called Built in inflation. Built-in Inflation is that kind of inflation which evolves from the past events and continues to affect the current economical conditions of a nation. Built-in Inflation may also be termed as Hangover Inflation.

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2.6 Causes of inflation:

The major causes of inflation are shortly described below:

1. Excess money supply: Money supply plays a large role in inflation. According to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a monetary phenomenon." If the Central Bank does not control the money supply adequately, it may actually grow at a rate faster than that of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates correspond with a high level of money supply and allow for more investment in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is available. The credit crisis of 2007 is a very good example of this at work. The study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that any change the amount of money in a system will change the price level. This theory begins with the equation of exchange:

MV = PQ

Where

M = the nominal quantity of money.V = the velocity of money in final expenditures;P = the general price level;Q = an index of the real value of final expenditures;

It is assumed that the velocity of money is unaffected by monetary policy (at least in the long run), and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With exogenous velocity (that is, velocity being determined externally and not being influenced by monetary policy), the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not exogenous in the short run, and so the formula does not necessarily imply a stable short-run relationship between the money supply and nominal output. However, in the long run, changes in velocity are assumed to be determined by the evolution of the payments mechanism. If velocity is relatively unaffected by monetary policy, the long-run rate of increase in prices (the inflation rate) is equal to the long run growth rate of the money supply plus the exogenous long-run rate of velocity growth minus the long run growth rate of real output.

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2. Unemployment: A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn today. There is an inverse relation between rate of inflation and the rate of unemployment in an economy. The more the entrepreneur extends the employment opportunity the more he has to pay to that particular factor of production and the more payment to factor of production the increase in the cost of producing a unit will be observed and in order to maintain the profitability of the product the entrepreneur will inflate the price of that product. A similar process will be observed throughout the economy when the government intends to create job. The price of products or services, where the workforce is installed, will increase hence an increase in the rate of inflation will be visible throughout the economy. Famous economist A.W Philips discovered a graphical way to show this relation which is known as Philips curve. Phillips curve showed that unemployment and inflation shared an inverse relationship: inflation rose as unemployment fell, and inflation fell as unemployment rose. Since two major goals for economic policy makers are to keep both inflation and unemployment low, Phillip's discovery was an important conceptual breakthrough.

Fig 03: Phillips Curve

The inflation rate is represented on the vertical axis in units of percent per year. The unemployment rate is represented on the horizontal axis in units of percent. The curve shows the levels of inflation and unemployment that tend to match together approximately, based on historical data.Though Phillip’s discovery was an important conceptual breakthrough, but also posed a troublesome challenge: how to keep both unemployment and inflation low, when lowering one result in raising the other?

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A solution of this problem is NAIRU (Non-Accelerating Inflation Rate of Unemployment) or the “Natural rate of unemployment”. That is, a steady state unemployment rate above which inflation would fall and below which inflation would rise. Generally this rate is 5.5% for most countries.Austrian view: The Austrian view asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrians stress that inflation affects prices in various degree, i.e. that prices rise more sharply in some sectors than in other sectors of the economy. The reason for the disparity is that excess money will be concentrated to certain sectors, such as housing, stocks or health care. Because of this disparity, Austrians argue that the aggregate price level can be very misleading when observing the effects of inflation. Austrian economists measure inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time.

Other aspect: There some other topic which are related to inflation. A brief description of these is given below:

2.7 Disinflation:

Disinflation is a decrease in the rate of inflation – a slowdown in the rate of increase of the general price level of goods and services in a nation's gross domestic product over time. It is the opposite of inflation.

If the inflation rate is not very high to start with, disinflation can lead to deflation – decreases in the general price level of goods and services.

2.8 Disinflation & sacrifice ratio:

If policy makers want to decrease inflation rate, they must increase unemployment (As there is a tradeoff).To decrease employment, output level must be sacrificed. The amount of decreased output is measured by sacrifice ratio. An economic ratio that measures the costs associated with slowing down economic output to change inflationary trends. The ratio is calculated by taking the cost of lost production and dividing it by the percentage change in inflation, and its quotient gives the loss of output per 1% change in inflation:

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Normally this ratio is 1:5; to decrease 1% inflation, 5% output should be sacrificed. This sacrifice is also denoted as pain of disinflation.

2.9 Rational expectation & possibility of painless disinflation:

An alternative approach to avoid pain of disinflation is to assume that people have rational expectations. This approach states that people optimally use all available information including information about current government policies to forecast the future. According to the theory of rational expectations, a change in monetary or fiscal policy will change expectations, and as evaluation of any policy must incorporate this effect on expectations.

Hyper inflation: Hyper inflation means extremely rapid or out of control inflation. When associated with depressions, hyperinflation often occurs when there is a large increase in the money supply not supported by gross domestic product (GDP) growth, resulting in an imbalance in the supply and demand for the money. Left unchecked this causes prices to increase, as the currency loses its value.

2.10 Effects of inflation:

General effect:

An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.

The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money.

Increases in the price level (inflation) erode the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds).

Positive effect:

Labor-market adjustments: Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster.

Room to maneuver: The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from

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the central bank, and open market operation, which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate.

Instability with Deflation: Economist S.C. Tsaing noted that once substantial deflation is expected, two important effects will appear; both a result of money holding substituting for lending as a vehicle for saving. The first was that continually falling prices and the resulting incentive to hoard money will cause instability resulting from the likely increasing fear, while money hoards grow in value, that the value of those hoards are at risk, as people realize that a movement to trade those money hoards for real goods and assets will quickly drive those prices up. Any movement to spend those hoards "once started would become a tremendous avalanche, which could rampage for a long time before it would spend itself." Thus, a regime of long-term deflation is likely to be interrupted by periodic spikes of rapid inflation and consequent real economic disruptions. Moderate and stable inflation would avoid such a seesawing of price movements.

Financial Market Inefficiency with Deflation: The second effect noted by Tsaing is that when savers have substituted money holding for lending on financial markets, the role of those markets in channeling savings into investment is undermined. With nominal interest rates driven to zero, or near zero, from the competition with a high return money asset, there would be no price mechanism in whatever is left of those markets. With financial markets effectively euthanized, the remaining goods and physical asset prices would move in perverse directions. For example, an increased desire to save could not push interest rates further down (and thereby stimulate investment) but would instead cause additional money hoarding, driving consumer prices further down and making investment in consumer goods production thereby less attractive. Moderate inflation, once its expectation is incorporated into nominal interest rates, would give those interest rates room to go both up and down in response to shifting investment opportunities, or savers' preferences, and thus allow financial markets to function in a more normal fashion.

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Negative effect:

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates unless the tax brackets are indexed to inflation.

With high inflation, purchasing power is redistributed from those on fixed nominal incomes, such as some pensioners whose pensions are not indexed to the price level, towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, higher inflation in one economy than another will cause the first economy's exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Hoarding: People buy durable and/or non-perishable commodities and other goods as stores of wealth, to avoid the losses expected from the declining purchasing power of money, creating shortages of the hoarded goods.

Allocative inefficiency: A change in the supply or demand for a good will normally cause its relative price to change, signaling to buyers and sellers that they should re-allocate resources in response to the new market conditions. But when prices are constantly changing due to inflation, price changes due to genuine relative price signals are difficult to distinguish from price changes due to general inflation, so agents are slow to respond to them. The result is a loss of allocative efficiency.

Shoe leather: High inflation increases the opportunity cost of holding cash balances and can induce people to hold a greater portion of their assets in interest paying accounts. However, since cash is still needed in order to carry out transactions this means that more "trips to the bank" are necessary in order to make withdrawals, proverbially wearing out the "shoe leather" with each trip.

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Menu change: With high inflation, firms must change their prices often in order to keep up with economy-wide changes. But often changing prices is itself a costly activity whether explicitly, as with the need to print new menus, or implicitly.

Business Cycle: According to the Austrian Business Cycle Theory, inflation sets off the business cycle. Austrian economists hold this to be the most damaging effect of inflation. According to Austrian theory, artificially low interest rates and the associated increase in the money supply lead to reckless, speculative borrowing, resulting in clusters of malinvestments, which eventually have to be liquidated as they become unsustainable.

2.11 Controlling inflation:

A variety of methods have been used in attempts to control inflation. They are shortly described below:

Monetary policy: Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level; normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy. There are a number of methods that have been suggested to control inflation. Central banks can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

Fixed exchange rate: Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a

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government from using domestic monetary policy in order to achieve macroeconomic stability.

Wage & price control: Another method attempted in the past have been wage and price controls ("incomes policies").In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime.

3.0 Current Situation of Inflation in Bangladesh:

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Rising rate of inflation has become a serious concern in Bangladesh in recent years. The impact of rising inflation rate is being felt almost everywhere. The prices of essential commodities have gone up, and so is the cost of living. Country’s vast multitude of poor and unemployed people is having a difficult time to survive.

Data from different sources on inflation of Bangladesh is given below to understand the gravity of the situation:

3.1 Bangladesh Economic Review & Bangladesh Bureau of Statistics:

The rate of inflation (national) in FY 2008-09 stood at 6.66 percent which was 9.93 percent in the previous fiscal year. From the table and graph given below, it is observed that there is an increasing trend of inflation from FY 2001-02 to FY 2007-08 but in FY 2008-09 the rate of inflation came down. During this period the food inflation is higher than non-food inflation. It is noted that the weight of food and non-food item in the urban-CPI are 48.8 percent and 51.2 percent and that in rural-CPI 62.96 percent and 37.04 percent respectively.

Consumer Price Index and Inflation

(Base year 1995-96=100)

Table 01: Rate of Inflation (National)

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Fig 04: National rate of Food & Non-food inflation

In the month of July of Fiscal Year 2009-10, point-to-point inflation was 3.46%. And ministry of finance estimated that the inflation rate of Fiscal Year 2009-10 was going to be 6.5%.

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Monthly Rate of Inflation (Point- to- Point) during FY 2009-10

(Base Year: 1995-96=100)

2008-09

Jul

’09

Aug

’09

Sep

’09

Oct

’09

Nov

’09

Dec

’09

Jan

’10

Feb

’10

Mar

’10

Average

Inflation

(July-March

)

National

General 6.66 3.46 4.69 4.60 6.71 7.24 8.51 8.99 9.06 8.78 6.89

Food 7.18 3.34 4.93 4.98 7.78 7.84 9.50 10.56 10.93 10.80 7.85

Non-food

5.91 3.74 4.54 4.28 5.07 6.44 7.04 6.53 6.14 5.60 5.49

Urban

General 6.28 4.09 5.81 6.15 6.06 8.27 9.10 9.44 9.29 8.70 7.53

Food 7.43 4.14 6.92 7.67 9.00 9.83 11.08 12.07 12.32 11.86 9.43

Non-food

4.80 4.03 4.39 4.20 4.34 6.27 6.60 6.18 5.57 4.83 5.16

Rural

General 6.83 3.21 4.25 3.99 6.62 6.83 8.27 8.81 8.96 8.81 6.64

Food 7.09 2.99 4.07 3.83 7.26 7.00 8.82 9.92 10.34 10.35 7.18

Non-food

6.33 3.62 4.60 4.30 5.34 6.51 7.20 6.65 6.35 5.89 5.61

Table 02: Monthly Rate of Inflation (Point- to- Point) during FY 2009-10

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3.2 International Monetary Fund

Variable: Inflation, average consumer prices

Note: Data for inflation are averages for the year, not end-of-period data.

Units: Percent change

Source: International Monetary Fund- 2010 World Economic Outlook

Fig 05: Year-wise chart of Inflation

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Table 03: Year-wise inflation rate & percent change

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3.3 CIA World Factbook

Fig 06: Year-wise bar chart of Inflation Rate

Table 04: Year-wise percent change in inflation rate

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4.0 Causes of Inflation in Bangladesh

It is true that Bangladesh has curbed the inflation rate compared to FY 2007-08, when inflation rate was 9.93%, Bangladesh is still under the threat of another huge up-rise in inflation. Some unofficial sources confirm that Bangladesh has already reached two-digit inflation rate this year. The major causes of today’s inflation are:

1. Increase in Food Price in Global Market: Any increase in international prices is, therefore, expected to be passed on to domestic prices through the import channel. We notice a secular increase in the prices of four major food items (rice, wheat, soybean oil and sugar) in the international market during 2001-2010.

Fig 07: Price of Rice (2001-2011)

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Fig 08: Price of Wheat (2001-2011)

Fig 09: Price of Soya (2001-2011)

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Fig 10: Price of Sugar (2001-2011)

Since Bangladesh is an import–dependent small economy, a positive relationship is expected to exist between world food prices and domestic inflation. As the weight of food items in the consumption is 58.84 percent at the national level, rising world food prices would influence overall inflation in Bangladesh.

2. Changes in Diesel Prices: Global oil prices have been rising steadily having macroeconomic impact on our economy.

Fig 11: Price of Diesel (2006-11)

To meet with this up-rise of prices in international market Bangladesh Govt. has recently increased fuel price to reduce subsidy burden which is going to add up to general inflation.

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Price of a liter of petrol has been fixed at 76 taka (104 U.S. cents) a liter, octane at 79 taka, diesel and kerosene at 46 and furnace oil at 42 taka.

3. Exchange rate fluctuations: Exchange rate is found to be significant in explaining inflation in Bangladesh. A depreciation of exchange rate translates into a rise in the cost of imported commodities by making foreign goods more expensive, and thus induces an increase in the domestic price level. There is a close association between exchange rate fluctuations and inflation. Exchange rate depreciates => increases the prices of imported commodities =>increases the inflationary rateSince the adoption of a floating exchange rate regime in May 2003, any depreciation of the exchange rate has been associated with a pickup in inflation by increasing the prices of imported goods.As the economy of Bangladesh greatly depends on that of India’s, the exchange rate between Indian rupee & BDT is to be noted in the graph given below:

Fig 12: Bangladeshi Taka & Indian Rupee Exchange Rate (Apr’10-Apr’11)

From the above graph we understand how Taka has lost buying power against Rupees. This enhances inflation in our economy.

4. Growth of money supply: The Quantity Theory of Money leads us to agree that the growth in the quantity of money is the primary determinant of the inflation rate. The excessive growth of money supply (M2) causes rising inflation by generating excessive pressure of demand in the economy. For last FYs rising inflation in Bangladesh has generally been associated with accelerated growth of M2.The charts given below will provide a more precise idea of our actual money supply & M2 growth from 2008-10.

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Table 05: Money supply in Jul’08

Table 06: Money supply in Jul’09

Table 07: Money supply in Jul’10

5. Increased inflow of workers’ remittances: Money supply for some years has been rising at a rapid rate due to accumulation of foreign exchange reserves. A robust growth of exports and a sharp increase in the flow of workers’ remittances have made foreign exchange reserve strong. The transmission mechanism of foreign exchange reserves is depicted in the figure below:

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Fig 13: Transmission Mechanism of Reserve Accumulation

On the one hand, the accumulation of reserves has added to reserve money by expanding the NFA holding of Bangladesh Bank, which in turn has led to faster money supply (through money multiplier).On the other hand, the accumulation of foreign exchange reserves has caused Taka to depreciate, which have added an upward pressure on inflation:

Bangladesh Bank pursues somewhat interventionist exchange rate policy.

In recent years, the foreign exchange market experienced excess demand for US Dollar arising mainly from continued price hike of oil and other major imported commodities.

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We can understand the accumulation of reserve by the following yearly chart of remittance inflow:

Table 08: Inflow of Remittance(*: data up to month of March of financial year 2010-2011.)

6. Inflation Inertia: Inflation inertia is found to have significant effect on inflation. A month’s inflation contains the influence of all previous months’ shocks, which form inertia for the following month. For example, the domestic market takes time to adjust to the falling prices of commodities in the international market.

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5.0 Effects of Inflation in Bangladesh: The inflationary situation in Bangladesh is on the rising trend, especially since

August 2009, primarily owing to the soaring increase in food prices. The food price hike has accelerated the general inflation rate in the country.Food inflation leaves a harmful impact on the purchasing power when the per capita GDP does not correspond with inflation. From August 2009 to June 2010, the food inflation has risen by 5.7 percent whereas GDP growth rate has fallen by 0.1 percent, indicating that the purchasing power of the people shrunk drastically.

Fig 14: Projected Food & Non Food Inflation Rates

Food inflation is higher in rural areas than in urban areas. Food inflation in rural areas reached near 11 percent, which is more difficult for the countryside population to cope with.Rural food inflation increased to 10.51 percent in September’10, which was 9.95 percent in August, while urban food inflation in September declined to 7.95 percent against 8.95 percent in August’10.Zaid Bakht, a research director of Bangladesh Institute of Development Studies, said it is probably because of differences in the consumption basket. Rice is a major part of the food basket for the rural people, which is not the case for urbanites.

The loss of Taka's value used to be not so quick in the past. The only difference now is that this loss has been accelerating in recent years that have created a specter of a vast number of people getting declassed and actually going down in the class hierarchy. Thus middle class people are turning into

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lower middle class ones and the latter in turn joining the ranks of the poor. And the poor are turning poorer from living costs fast outpacing earnings and buying powers of non-affluent sections of people decreasing dramatically from the lower purchasing power of the currency as such or the lowered value of their savings.

We can say that inflation also directly lowers living standard. When prices go up, buyers of goods and services do pay more for what they buy. Inflation has an additional cost, however, when it comes as a surprise. Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need.

Nominal income: income measured in monetary units. (Such as, dollar, euro, and taka)Real income: income measured in physical units of product. (Units of rice, chicken and prices of product).

Real income Nominal income

(Adjusted for inflation) = ------------------------

Price level

Example: if price of any goods (as-bread) was 100 before one year, now in today market now it cost 110 taka. Because of inflation people enjoy same amount of product at higher price. The number of taka risen by 10 % But each of taka can buys less than it did one year ago.

There exists a positive relationship between food inflation and poverty. As the food inflation increases, the additional number of people goes under the poverty line.

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6.0 Policy Options:

The above analysis suggests that both demand and supply side factors constitute the sources of the recent inflation in Bangladesh. Based on these facts, the chance of declining inflationary trend in Bangladesh is slim in the near future. In order to keep inflation under control, the government has already taken some measures like; the government measures include enhancing and improving the existing public food distribution system, undertaking regular market surveillance, a cut in the interest rate & reduction/exemption of tariff for import of some essential food items. However, the government needs to take more measures to contain the price spiral.

We propose a number of policy recommendations for dealing with high inflation. These policy recommendations are divided into demand-side and supply-side policy measures.

1. Demand-Side Policy Measures: To contain inflationary pressure in the economy, the growth of broad

money should be in line with the estimated real GDP growth and a target for the inflation rate.

As the government borrowing from non-bank sources is mainly non-inflationary, the government may prefer to borrow more from non-bank sources (national savings schemes) by reinstalling/introducing some long-term savings schemes as were in force earlier.

Measures may be taken to make the exchange rate responsive to that of neighboring countries especially India by shunning the interventionist exchanges rate policy of Bangladesh Bank.

The growth of reserve money arising from reserve accumulation may be offset by sterilization. Bangladesh Bank may sell government securities for which it will have to pay interest.

2. Supply-Side Policy Measures: The government should maintain sufficient buffer stock of food grain

(rice and wheat) in order to meet any kind of shocks. This will instill confidence in people.

The existing information dissemination system on the prices of essential commodities may be strengthened by using electronic and print media.

The surveillance on the part of the government may be enhanced through weekly monitoring of domestic and international prices of essential commodities.

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To inject competition in the market, the government should promote small and medium traders along with big importers for import of essential commodities, and help them get credit from commercial banks.

The government should promote the establishment of producers’ cooperatives, which will work towards ensuring fair prices of their products, and at the same time help eliminate unnecessary agents in the supply chain. This will help stabilize the market price.

More investment in the agriculture sector is needed to undertake research and extension work in order to invent/upgrade modern technology to boost agricultural production, strengthen capacity in storage, marketing and management along with setting up of agro-based industries.

Like the Indian state trading agencies, the government should use the experience of Trading Corporation of Bangladesh (TCB) by strengthening its capacity with skilled manpower to break up any collusive oligopolistic power exercised by the private sector and thus improve the competitiveness of the distribution network.

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7.0 Conclusion

In this report we used data from various source to draw a clear, concise & precise picture of current scenario of inflation in Bangladesh. To do that we tried to find out the causes behind the current upraise in the rate of inflation & then we showed the

effect of it on our economy and people.

Moreover, from our findings we recommended some policy measures to control this current upraise in inflation. And of course the Government of Bangladesh &

Bangladesh Bank has to be more watchful to keep this whole situation under control.

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8.0 References

Bibliographical References:

Macroeconomics byN. Gregory Mankiw

Macro Economics byRudiger Dornbusch, Stanley Fischer & Richard Startz

Institutes:

Ministry of Finance, Bangladesh Bangladesh Bureau of Statistics Bangladesh Bank

Journals:

Bangladesh Economic Review (2009-10) Major Economic Indicators, Bangladesh Bank, April ‘11 Bangladesh Economic Update, Vol. 2, no. 1, Jan-Feb ‘11

Websites:

www.banladesh-bank.org www.adb.org www.imf.org

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