A Forward Looking Small Semi-Structural Macroeconomic Model For Bangladesh

Small semi-structural models are suitable to explicate the monetary transmission mechanism by recognizing the interrelationships among major macroeconomic variables. This study presents a small semi-structural dynamic general equilibrium (DGE) New Keynesian model for Bangladesh to explore the dynamic interrelationships among major macroeconomic variables related to the transmission mechanism of monetary policy. Our DGE model comprises of four key behavioral equations – the aggregate demand (output), aggregate supply (inflation), interest rate and, the exchange rate. Using quarterly data over the sample period from 2006:Q3 to 2016:Q2, we have used Generalized Method of Moments estimation technique, which is useful for estimating forward-looking reaction functions on the basis of expected values for macroeconomic variables. The findings demonstrate that the model is inclusive enough to capture how the selected variables are interrelated. In most of the cases, the study finds significant and similar nature of interrelationships among the major macroeconomic variables as found by previous studies on Canada, Thailand, and South Africa. The model is also flexible enough in understanding shock propagation and conducting policy analyses. For Bangladesh, the policy transmission mechanism is found less efficient to control the monetary system (over 10 years to revert to steady state after the occurrence of shocks), while Canada, South Africa, and Thailand need 5 years, 10 years, and 10 years, respectively. This happens mainly due to the weak monetary policy which has two consequences. First, a small reaction parameter in the interest rate equation which means that the interest rate is only marginally adjusted to high inflation. Second, a small effect of monetary policy on the economy through the output and exchange rate equations. Most notably, in the exchange rate equation, the uncovered interest parity indicates a low coefficient. This might happen due to the absence of inflation targeting monetary policy in Bangladesh. A strong and quick policy response is required which could be achieved by implementing two major policy tasks: adoption of an inflation-targeting monetary policy, and full autonomy of Bangladesh Bank in both administrative and functional areas.