CPD contends that credit control and increased prices of natural gas, fertiliser, power, and petroleum products, will only worsen the supply-side factors, adding fuel to cost-push inflation. The BB is advised to limit unproductive credit to the government sector instead of pursuing the policy of hamstringing the private sector with credit crunch.

The controversy between BB Governor Salehuddin Ahmed and CPD's Executive Director Debapriya Bhattacharya arose because of a possible mis-diagnosis of the reasons of the price spiral. The BB's contractionary policy is prudent if the persistence of price spiral is identified as demand-push. The CPD's policy prescription is plausible if the price spiral is cost-push.

Sandwiched in the controversy is the IMF resident representative Jonathan Dunn, who dodged the accusation of IMF's heavy-handedness in twisting the arms of BB to pursue a contractionary monetary policy -- one that was outright denied by the Finance Adviser Mirza Azizul Islam, Energy Adviser Tapan Chowdhury and BB Governor Salehuddin Ahmed. However, I interpret the statements of the IMF economist differently.

Jonathan said IMF had advised Bangladesh on several occasions to take tighter monetary measures. He added, "Now we are encouraged to see that the central bank has adopted an appropriate policy." (DS July 16).

About the CPD'c contention that the IMF is imposing its policy prescription on the BB he said: "I would like to say the discussion that is going on regarding monetary policy is part of a healthy debate."

Jonathan suggested that the country should adjust fuel and energy prices to the international level on a regular basis. My rejoinder: What about people's income, and the affordability of products that are energy based.

Citing the inflation rate in May, he said the highest rate of inflation wasn't in food items or transport. My rejoinder: How could any one make such an observation by watching just one month's food prices ?

The IMF economist argues that furniture, household appliances, and some other services and goods were affected by inflation, which is actually not related to the supply side. Is he suggesting that making these products domestically does not need labour, energy, and raw materials, which constitute supply side factors? My rejoinder: Maybe I went to the wrong school to study economics.

In my analysis, the IMF economists' comments are rhetorical, rather than empirical economics based.

The rise in the prices of energy products causes an increase in the variable costs of firms for which energy products are an essential input for the production process. This has an inflationary effect on the general price level, but a deflationary effect on real output.

The final magnitude of the effect of energy price increases (or any other important supply-side factors) is dependent on the price elasticity of aggregate-demand (AD).

Aside from sustained money growth that encourages sustained growth in AD, government borrowing can also put upward pressure on the AD within certain limits and, hence, induce upward pressure on prices (See DS April 21, 2005, "Corruption, budget deficits…).

Beside any policy-initiated money growth, persistent budget deficits and enveloping corruption can also increase money growth and, hence, inflation. For example, as budget deficits are monetised by the CB, the money supply increases. These deficit-induced increases in the money supply cause AD to increase, and the resulting supply-demand imbalances in the goods market drive up the general price level.

Before resorting to a contractionary monetary policy the BB must assure that the inflationary pressure is demand-pushed. Otherwise, the policy would be counterproductive -- as Debapriya passionately and plausibly argued.

The experience of the confluence of excess liquidity in the banking system and sluggish investment demand suggest that the price spirals are not being triggered by increases in AD.

The interim government's all-encompassing campaign against corruption must have dampened some corruption induced increases in the AD. Besides, the government's relentless efforts to regulate the market by eliminating non-price competition such as hoarding, price gauging, and market manipulations by syndicates may have also held back the potential for accelerated inflation (See DS March 25: Market failure and price spiral). These measures are expected to have some mediating effects on inflationary expectations as well.

Why hasn't the price spiral responded significantly to the government's anti-inflationary measures? I suspect that in addition to externalities contributing to "market failure" the economy may be experiencing some degree of what is known as "stagflation" -- a word coined in the 1970s to describe simultaneous experience of slow growth and high inflation.

Stagflation had not been experienced previously in the industrialised economies because decreased AD resulted from a recession that usually produced lower, or at least stable, prices. Large US government deficits and sharp rises in the cost of energy have been cited as the principal causes of stagflation in the 1970s. Don't both budget deficits and high energy cost prevail in Bangladesh?

In neo-classical economic theory, stagflation is rooted in the failure of the overall market (market failure) to allocate goods and services efficiently. Other theories view stagflation as an adverse-supply shock (a sudden increase in the price of oil, natural disaster, labour strikes etc.) induced phenomenon.

Prior to 1/11 the Bangladesh economy had been subjected to persistent adverse-supply shocks due to fertiliser shortages, higher energy costs, hartals and lock-outs. Hence the persistent price spirals may be largely due to adverse-supply factors -- a precursor to stagflation.

To counter stagflation the CB can make one of two choices, each with negative outcome. First, stimulating the economy by increasing the money supply (monetising the government debt) entails the risk of fueling the pace of inflation. Alternatively, a tight monetary policy (reducing government debt and raising interest rates) to reduce inflation involves the risk of slower output growth.

The choices for fiscal policy are far less clear. However, increasing prices of fertilisers and energy products are not only counterintuitive -- they will also make the price spiral self-propelling.

What's instructive for Bangladesh Bank is that if CPD's recommendations for supply-side stimulants are implemented and CPD is mistaken, the economy would still benefit from increased investment, lower cost of production, and lower product prices, but implementing BB's contractionary policy without correctly identifying the sources of price spirals would drag the economy to a recession -- an impeachable action.

Dr. Abdullah A Dewan is a professor of Economics at Eastern Michigan University