Why quantity theory of money fails in Bangladesh

In economic policy debates, some ideas endure not because they explain reality well, but because they sound reassuringly simple. One such idea is the belief that inflation can be understood-and managed-by tracking how much money exists and how quickly it circulates through the economy. In Bangladesh, this mode of thinking quietly shapes monetary policy discussions and official statements, even when it is not stated explicitly.

The problem is not that the logic is mathematically wrong. The problem is that it assumes an economy far more orderly than the one Bangladesh actually inhabits.

At the heart of this reasoning lies what economists call an identity. An identity is neither a theory nor a prediction; it is a statement that must always hold true by definition. Total spending in an economy must equal total income, because one person's spending is another person's income. Such statements describe how numbers balance after the fact. They do not explain how people behave or how economies respond to policy. Confusing an identity with a governing rule is like mistaking a thermometer for a thermostat.

In monetary economics discussions, this identity links four quantities: the total amount of money in the economy (M), how often that money changes hands (velocity = V), the general level of prices (P), and the total amount of goods and services produced (real GDP=Y). Expressed mathematically: M × V º P × Y

This relationship always holds after the economy has already done whatever it was going to do. It is therefore an ex post accounting identity, not a behavioral law. The symbol ‘º’(three dashes) denotes an identity, not an equality that implies causation. It is used deliberately to distinguish an accounting truth-which always holds by definition-from a behavioral or policy relationship, which may or may not hold in practice.

Policymakers, particularly in developing economies, often go a step further. They assume that if the supply of money increases, and if money circulates in a stable and predictable way, then prices or output must adjust in a manageable and foreseeable manner. That additional step is not arithmetic. It is a behavioral and institutional assumption. In Bangladesh, that assumption fails.

To see why, it helps to understand what economists mean by the "velocity" of money. Velocity simply refers to how frequently money is used in transactions over a period of time. If people spend quickly and repeatedly, velocity is high. If they hold on to cash, velocity is low. In economies with stable institutions, predictable rules, and trust in the future, velocity usually stays within a narrow range and tends to return to normal when disturbed.

Bangladesh's economy does not behave this way.

Money here does not circulate according to stable habits or predictable confidence. It circulates according to fear, coercion, uncertainty, and survival. When people rush to spend money quickly, it is often not because they feel optimistic, but because holding money feels unsafe. When money slows down, it is not because demand is weak, but because people are paralyzed by uncertainty. Informal tolls, forced payments, political extraction, and sudden regulatory shocks constantly disrupt normal spending behavior. As a result, the speed at which money moves is not anchored to economic fundamentals; it is driven by institutional anxiety. Treating such movement as a reliable policy signal is deeply misleading.

Even more problematic is the assumption that increasing the supply of money increases usable money for the economy. On paper, Bangladesh may appear flush with liquidity at various times. In practice, access to credit is sharply unequal. Politically connected borrowers absorb large volumes of funds without repayment discipline, while productive firms, especially small and medium enterprises-struggle to obtain financing. Banks respond rationally to this environment by protecting themselves rather than expanding risk-taking. The result is a familiar paradox: money exists, but it does not flow. Expansion looks impressive in official statistics but weak on factory floors.

Prices add another layer of distortion. In textbook economics, prices are signals. They rise when demand outpaces supply and fall when competition intensifies. In Bangladesh, many prices are not signals at all; they are outcomes of power. Food prices are influenced by syndicates. Transport costs embed layers of informal payments. Housing rents include protection costs and political risk. Energy prices reflect administrative timing rather than market pressure. When prices rise in such an environment, they often reflect extraction, not overheating. Treating this inflation as a purely monetary phenomenon misidentifies the problem and prescribes the wrong response.

Output-the economy's capacity to produce more goods and services-faces its own non-monetary ceilings. Power shortages, port congestion, bureaucratic delays, toll extraction, and policy unpredictability all limit expansion. Even when money is available and demand exists, firms cannot respond smoothly. Production is constrained by institutions, not finance. As a result, attempts to stimulate or restrain the economy through money alone produce lopsided outcomes: prices adjust more easily than production, and workers absorb the costs while extractive structures remain intact.

None of this implies that monetary policy is irrelevant or that central banking is futile. It means that monetary tools cannot substitute for institutional integrity. When governance is weak, extraction dominates, and trust is fragile, simple macroeconomic relationships lose their guiding power. They remain mathematically correct but causally empty and policy-irrelevant.

The real danger lies in mistaking numerical consistency for economic control. When policymakers rely on identities as if they were levers, they risk tightening when reform is needed, restraining demand while ignoring extraction, and disciplining workers while leaving rent-seekers untouched. The result is policy fatigue without resolution.

Bangladesh's challenge is not that its central bank understands too little economics. It is that economic reasoning is applied without sufficient regard for institutional reality. Monetary thinking must move beyond aggregates and ask harder questions: who actually receives credit, who sets prices, who extracts value, and who ultimately pays for adjustment. In economies where trust, competition, and enforcement function reasonably well, simple relationships can guide policy. In economies where fear replaces trust and extraction replaces return, those same relationships become mirages. They describe what adds up-but not what drives outcomes.

To bridge this gap between theory and reality, the Bangladesh Bank must transition from tracking M2 aggregates to monitoring Institutional Friction Indices. If the velocity of money is driven by institutional anxiety, then policy success must be measured by the narrowing of the "Credit-to-Extraction Gap." This requires prioritising the flow of liquidity to productive firms over the volume of credit absorbed by politically protected syndicates.

The lesson is uncomfortable but unavoidable. Numbers do not govern economies. Institutions do. True monetary stability will not be found in the manipulation of accounting identities, but in the aggressive dismantling of the non-monetary ceilings-the syndicates, informal tolls, and extractive barriers-that render traditional policy tools irrelevant. And no identity, however elegant, can compensate for their absence. The choice for policymakers is clear: continue to manage a mathematical mirage, or begin the difficult work of rebuilding the institutional foundations upon which a real economy stands.

Dr Abdullah A Dewan, Professor Emeritus of Economics, Eastern Michigan University (USA) and Former Physicist and Nuclear Engineer, Bangladesh Atomic Energy Commission.
aadeone@gmail.com