Measuring inflationary pressure in Bangladesh: the P‐Star approach

Abstract

The paper estimates the P* model for the Bangladesh economy and tests its forecasting ability through generating recursive forecasts. The model puts together long run determinants of price level based on the classical quantity theory of money and short term changes in current inflation. The empirical results show that the model performs relatively well and contains additional information regarding future rates of inflation. The price and output gap models fare consistently better than the velocity gap model which brings out the importance of non‐monetary factors in explaining inflation dynamics in Bangladesh. The out of sample forecasts show that the price gap model performs better followed by the output gap model and the velocity gap model. With financial sector liberalization and reforms, it is likely that the scope for the P* model to play a more proactive role would be ramified in Bangladesh.