Defending the indefensible

In a recent article, entitled, “Economic expansion with monetary contraction” Professor M A Taslim presented a blueprint while addressing various aspects of the state of Bangladesh economy and the Monetary Policy Statements (MPS) of the Bangladesh Bank (FE, February 27, 2023). I sincerely believe that the economy and the country would immensely benefit if the government pays serious attention to his recommendations. I am only attempting to throw some light on one aspect of the problem with BB’s MPS raised by Professor Taslim, He writes, “In standard economic parlance a contractionary or tight policy is one that contracts aggregate demand so as to create a slack which is expected to reduce any inflationary pressure. A rather novel aspect of the MPS is that it expects its contractionary monetary measures to accelerate economic expansion from 6.03 per cent last year to 6.5 per cent this year, and the inflation rate is expected to fall to 7.5 per cent from the current 9.4 per cent. The numbers are made consistent perhaps by a mechanical application of the quantity equation”. 
First, the equation of exchange (MV = PY, where M = Money stock, V = Transaction velocity of money, P = Price level, and Y = Real GDP) — more famously known as the monetarist model of the quantity theory of money, is an identity, an equilibrium equation only applicable for advanced economies and even then, it is not used for any policy prescription.
There is no disagreement with Prof. Taslim’s assertion that achieving economic growth by contractionary monetary policy is a novel or innovative idea. In fact, that is not what we teach in macroeconomics. That said, I may argue that a coordinated contractionary monetary activism to tame inflation with favourable fiscal policy measures may achieve economic expansion with low inflation – but not that easily implementable though because of resource constraints and political inhibitions. First let us look at the flow diagram showing the channels of monetary transmission for the benefits of general readers. 
Multiplier model of the money supply

In the equation, the factor in the parenthesis is called the money multiplier “m”.

Ms = Money supply,
B = Monetary Base = Total reserves + currency in circulation outside the commercial banking system.
= Required Reserves + Excess Reserves + currency in circulation
= Total reserves + currency in circulation
B = TR + C
Rd = Percent of reserves banks hold against demand deposits (example, say 13%)
Rt = Required reserves against time deposits (say, 5%)
c = C/D: Ratio of public’s currency holding against their holding of demand deposits
t = T/D: Ratio of public’s holding of time deposits against their holding of demand deposits
x = ER/D: Percent of excess reserves Banks hold against their holding of demand deposits liabilities ss 

Contractionary monetary policy shifts the aggregate demand (AD) from AD1 to AD2. Equilibrium real GDP decreases from Y1 to Y2 with Price level falling from P1 to P2. A country cannot achieve economic expansion (BB’s MPS) by contractionaey monetary activism. What if the currrent high inflation rate is both AD and AS driven?In that case, contractionary monetary policy will not succeed in tamimgn inflation.
To increase real GDP during the period of monetary contraction, the government’s pragmatic fiscal policy may help to accomplish that goal. How so? This is possible if the government can influence the AS factors by adding more productive physical capital (boosting labor productivity), import much needed raw materials for industries, procure oil and other energy products at favorable prices. With Rooppur Nuclear Power plants being in the process of supplying energy at favorable prices, there exists a bright prospect for energy self-sufficiency.
The government can also initiate some form of supply side tax cuts on interest income from savings, business investment on new capital equipment etc. Providing these productive factors of supply would shift the AS function rightward to over compensate the leftward shift of the AD function, achieving double yummy of lower price level and higher real GDP.
Bangladesh economy is experiencing high inflation rate with twin deficits – current account deficits and budget deficits. If for whatever reason the economy’s current level of output falters – which is likely to happen with twin deficits and inflation taming monetary contraction, the economy will then be experiencing stagflation – inflation accompanied by declining real GDP and rising unemployment. Most symptoms of the sources of current stubborn inflation appear AS factors driven. Given this diagnosis, monetary contraction will not be of much help and may only add to the economic hardship and miseries to the have-nots. The recipes to counter this probable eventuality, implementing some aspects of supply side economic policy tools may be prudent. 
Supply-side economics (SSE) theory promotes the idea that creating a favourable business climate by reducing taxes and relaxing production-constraining regulations facilitates job creation, aggregate expenditure, and hence growth. What about the tax cut driven revenue short fall? Well, the proponents of the SSE claim that the higher growth will generate enough revenues which will more than offset the lost tax revenue.
Supply sides argue that the effect of tax cuts works on a 1-for-1 basis — that is “every dollar cut in taxes reduces government spending, and its stimulative effect, by exactly one dollar”. However, that same tax cut triggers a multiplier effect on growth — that is, one dollar in tax cut translates into more than one dollar of aggregate demand, which stimulates business expansion and in turn, additional job growth. Cutting taxes on dividends, capital gains, and interest income encourages people to save and invest.
The supply side stimulus is often labeled as trickle-down economics which promotes the notion that investors, savers, and business owners are the real engines of growth. Therefore, what benefits the wealthy will trickle down to everyone down the line, resulting in job creation and hence poverty reduction as witnessed in many developing countries including those of East and Southeast Asia.
The idea is that a corporate tax cut generates windfall funds to invest in capital equipment, creates jobs, and hence output expansion. On the other hand, a payroll tax cut incentivises workers to continue employment and others are attracted to join the labour force, increasing labour supply. As a result, the AS curve will shift rightward (See AS - AD model) with the dual rewards of economic growth with declining price level – as though killing two birds with one stone. In the figure, AS curve shifts from AS1 to AS2 with equilibrium GDP at Y3 and price level at P3 – a double yummy accomplishment. How likely are such gains realisable? Well, in the context of Bangladesh, some divine intervention would be handy in both cases – more so in the case of achieving GDP growth with monetary contraction than gaining double yummy outcome with positive supply shocks.
Although the SSE theory’s primary building block is tax cut, its broader perspective is the working of trickle-down economics. In other words, whatever monetary and fiscal policy tools exert favourable effect on the determinants of AS would be golden for the economy regardless of the state of the economy being in a recessionary trap, stagnation trap, high inflation trap or stagflation. The trickle-down economics phenomenon may not have produced desirable growth outcome to advanced economies, it has worked remarkably in curving poverty in China and its trading partners, Southeast Asian countries, including India.    

Dr. Abdullah A Dewan, formerly a physicist and a nuclear engineer at Bangladesh Atomic Energy Commission, is Professor of Economics at Eastern Michigan University, USA. [email protected]