Monetary policy is a macroeconomic policy that is used to achieve macroeconomic goals such as consumption, liquidity, growth and inflation by the country’s government. Bangladesh bank is currently following a price targeting based monetary policy and it will be continued up to FY18. Bangladesh bank is prioritizing in building up strong capabilities in forecasting and eradicating impediments to financial pricing which is market based. Current monetary policy of Bangladesh is supporting manufacturing which is employment-focused, green project sub sectors and FDI facilitation. According to Bangladesh bank’s monetary program, growth ceiling of Domestic Credit (DC) is consistent with inflation and growth objectives. Bangladesh bank is ready for adjustments in rate of policy. There is robustness in the momentum of output growth followed by uptrend in food price. Global inflation may cause mitigation in the risk of domestic inflation. According to Bangladesh bank, monetary aggregates enhancing smoothly within the growth ceiling though domestic credit and inflation are remaining below the ceiling (Monetary Policy Statement, BB, 2017).

The prominent Stanford economist, John Taylor invented and published Taylor’s rule from 1992-1993. Taylor’s rule is the form that shows how nominal interest rate which is set by government changes in output gap, inflation and other economic variables. It’s a forecasting model which is used to determine the shifts of interest rate in the economy. Taylor’s rule recommends that central banks should increase interest rates when employment surpasses full employment level or inflation is high. Conversely, interest rates must be decreased while employment levels and inflation are low. According to Taylor’s rule, policymakers should not follow algebraic formulations. Policy performances are generally improved by credible and systematic features of rules. A new policy would do better when the existing policy is not doing well. According to Taylor’s rule, if inflation rises above 2% of target or real GDP increases over trend GDP then the rate of federal funds also rises. The coefficients of the rules are used to make easy discussions. The rate of federal funds is influenced by the changes in real GDP and inflation and those emerged from updated research. Taylor’s rule is based on interest rate (short term), full employment and inflation. Taylor’s rule indicates that, the central bank should adjust the nominal interest rate in response to deviations of inflation from target and output from potential. On the other hand, it reduces interest rates to stimulate output (Taylor, 1993).

The objective of this paper is to analyze the monetary policy of Bangladesh during 1972-2016 in terms of bank rate, inflation rate and output gap in accordance with the Taylor’s rule. Moreover, this research intends to estimate whether the monetary policy of Bangladesh is following the Taylor’s rule and whether there is any long run relationships among bank rate, inflation rate and output gap of Bangladesh over the period 1972-2016.

There were few previous studies regarding monetary policy of Bangladesh to be examined to find out the gaps, differences and motivations of this study on Taylor’s rule. There is an association between inflation and domestic borrowing in Bangladesh and Bangladesh is affected by double-digit inflation which is resulted from the borrowing of the government of Bangladesh (Islam & Kabir, 2012). Because of positive association between policy shock and output, monetary policy of Bangladesh is playing a significant role in macroeconomic stability (Younus, 2017). Monetary policy was affecting financial stability and real economy of Bangladesh through changes in policy stance, asset prices and bank lending (Rafiq, 2015). Developed countries rather than developing countries follow rule based monetary policy such as Taylor’s rule (Islam, 2009). To reduce poverty and to accelerate growth, Bangladesh bank should undertake inflation targeting framework to achieve output growth and price stability (Islam & Uddin, 2011). Lending rate, deposit rate, real GDP, output, inflation, money supply and interest rate are the most significant variables to foster the monetary policy in Bangladesh during 2006-2016 (Younus & Roy, 2016). The previous studies lack behind from considering or applying Taylor’s rule to examine the monetary policy of Bangladesh. Besides as Bangladesh bank adopts short term interest rate to conduct its monetary policy, Taylor’s rule should be examined and that’s how it motivated to conduct and choose this study.

The rest of the paper is structured as follows. Section 2 describes a brief review of the relevant literature. Section 3 depicts a theoretical model that captures the Taylor’s rule. The econometric estimations for the long run relationship among the variables are set out in Section 4. Section 5 concludes with some concluding remarks.