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Bangladesh Bank, the central Bank of Bangladesh is committed to maintain price stability and facilitate economic growth through conventional monetary policy. Although Bangladesh entered the regime of floating exchange rate in 2003, central bank intervenes to minimize excessive fluctuation in exchange rate through foreign exchange intervention policy. While these two policies work simultaneously, there was no study to examine the performance and effectiveness of these policies and understand their interaction in the framework of a joint analysis. The paper intends to fill up this gap. The paper develops a structural vector autoregression (SVAR) model to understand how foreign exchange intervention and conventional monetary policy affects the economy along with the endogenous reaction of policy variables. The intervention policy and conventional monetary policy are jointly analyzed to understand the interaction between them and also their impact on exchange rate and other economic variables i.e., price levels, real economic activity and real financial asset prices. The SVAR model is identified through relevant exclusion restriction based on the literature and the reality of the economy of Bangladesh. Monthly data of the relevant variables from July 2003 to December 2014 are used to estimate the model. Impulse response function is used to reveal the impact of policy and other shocks.Results reveal that foreign exchange intervention shocks have significant effects on the Taka / US $ exchange rate and the contribution of foreign exchange intervention shocks to exchange rate fluctuation is larger than that of monetary policy shocks. However, intervention shock has virtually no impact on price level, economic activity and real asset price supporting sterilization. On the other hand, while conventional monetary policy has insignificant effect on relevant variables when its effect is examined excluding foreign exchange intervention policy, it has mostly significant impact on economic variables when joint analysis is conducted. Both monetary policy variable and foreign exchange intervention variable react to each other significantly, suggesting the usefulness of this joint analysis. Results also reveal appropriate policy reaction to economic situation. Central Bank’s policy interventions are working pretty well in achieving internal and external stability of the value of local currency. Hence, present framework of exchange rate intervention and monetary policy may be continued without any major overhaul. However, monetary policy has limited impact on economic activity measured by industrial production. Hence, to the extent growth is adversely affected by inflation and exchange rate fluctuation, the central bank may work towards achieving higher growth indirectly by maintaining low inflation and exchange rate stability. [ABSTRACT FROM AUTHOR]

Economies around the world are interdependent with one another in the present era of globalization. While some global shocks may affect the countries of the world together, domestic policies of a country sometimes can hardly work independent of external factors. Keeping these in view, a large body of literature has developed to address the impact of external shock on domestic economy as well as examining effectiveness of domestic policy in the context of an open economy. While effectiveness of monetary policy has been well studied in the context of both developed world as well as in the developing countries, only a few studies have been conducted in this field in Bangladesh and all these studies are made in a closed economy framework. Moreover, there is no study to formally examine the impact of external shock in Bangladesh. On this backdrop, the present paper makes an attempt to simultaneously assess the impact of external shock and that of monetary policy on the economy of Bangladesh. It builds up a structural vector autoregression (SVAR) model of Bangladesh in an open economy set up. Contemporaneous restrictions are set based on the spirit of the existing literature and the specific condition of Bangladesh economy. The SVAR model is estimated with quarterly data ranging from the year 1989 to 2013. Impulse response function and the variance decomposition analysis are used in exploring the importance of monetary policy and external shocks in explaining variation in domestic price level and output. Estimated Impulse response functions show that innovation in reserve money has a positive impact on price and output, although impact on price level is less significant. On the other hand external shocks seem to have more prominent impact on the domestic economy. Innovation in OECD GDP also has significant positive impact on domestic output of Bangladesh. Shocks in foreign price have an immediate positive impact on domestic prices. Variance decomposition exercise shows that external shocks weight more in explaining variation in domestic price and output compared to the monetary policy. Furthermore, effectiveness of monetary policy in the open economy model of Bangladesh economy seems to be lower compared to that in a closed economy version of the economy, implying that exposure to the rest of the world dilutes the effectiveness of domestic policy of Bangladesh. The findings have important implications. First, as monetary expansion has positive impact on price level, monetary tightening would be the right policy in controlling inflation. However, this may not always bring high success if the external factors are not favorable as the study finds importance of external factor affecting both price level and GDP. On the other hand, as innovation in OECD GDP has positive impact on GDP of Bangladesh, global recovery may have a positive stimulus to GDP growth of the country. [ABSTRACT FROM AUTHOR]