Does monetary policy matter in a less developed economy? Evidence from Bangladesh

This paper explores the role of monetary policy in the context of a less developed economy. Monetary transmission mechanisms in less developed economies can be quite different from an industrialized economy, as unlike industrialized countries, these economies are characterized by the small size of organized financial markets, limited substitutability between money and other assets and weak fiscal and monetary institutions. We utilize the Structural VAR approach to analyze the monetary transmission process and impacts of monetary policy on different macro variables in Bangladesh. Monetary policy shocks are identified using non-recursive contemporaneous restrictions, which are based on the Central Bank's reaction function and the structure of the economy. We found strong evidence for the interest rate channel of monetary policy in Bangladesh. Our findings indicate that monetary policy shocks are important sources of fluctuations in the rate of interest, output and prices. Expansionary monetary policies are found to be harmful for achieving price stability in Bangladesh, as they not only increase the prices permanently, but also make the price level more volatile. We also found the evidence of a long lasting effect of monetary policy on output, which suggests that contractionary policy measures may create sustained recession in Bangladesh.