Published: 09:54 AM, 10 August 2026
The Fallacy of Pass-Through Under Depreciation-Driven Inflation
The idea that exchange rates should adjust in line with inflation differentials is deeply embedded in open-economy macroeconomics. The logic is elegant: when domestic prices rise faster than those of trading partners, a corresponding depreciation preserves real competitiveness, protects exporters, and discourages imports. For a country like Bangladesh, where export earnings and remittances are central to external stability, this principle has often guided policy thinking. Yet, this rule of thumb breaks down in a critical situation - when inflation itself is caused by currency depreciation. In such a case, exchange rate pass-through ceases to be stabilizing and instead becomes self-defeating.
Bangladesh’s recent macroeconomic trajectory illustrates this tension vividly. Following the pandemic, global commodity price shocks and geopolitical disruptions significantly altered the balance of payments landscape. Import payments surged, particularly for fuel, food, and industrial inputs, while financial inflows became more uncertain. Foreign exchange reserves, which had reached around USD 48 billion in 2021, declined to the range of USD 38–40 billion in subsequent years. These pressures necessitated adjustments in the exchange rate, leading to a gradual depreciation of the taka.
However, this depreciation did not occur in a vacuum. Bangladesh is a highly import-dependent economy, particularly for energy, edible oil, fertilizer, and capital machinery. As the taka weakened, the domestic currency cost of these imports increased sharply. This fed directly into production costs and consumer prices, pushing inflation to elevated levels. Importantly, this inflation was not primarily driven by excess domestic demand or monetary expansion; rather, it was cost-push inflation triggered by exchange rate depreciation and global price shocks.
Herein lies the policy dilemma. If inflation is rising because the currency has depreciated, does it make sense to depreciate further in response to that inflation? The conventional prescription would say yes, in order to maintain real exchange rate parity. But in practice, this approach risks creating a feedback loop. Depreciation increases import prices and inflation; higher inflation then justifies further depreciation; and the cycle continues. Instead of stabilizing the real exchange rate, the economy enters a depreciation-inflation spiral.
This dynamic is particularly problematic for Bangladesh because of the structure of its trade. On the export side, while the ready-made garment sector has shown resilience, its responsiveness to exchange rate changes is not unlimited. Export volumes depend not only on price competitiveness but also on compliance standards, buyer relationships, supply chain efficiency, and global demand conditions. A weaker taka does not automatically translate into proportionately higher export earnings, especially when contracts are denominated in foreign currency and margins are already compressed.
On the import side, demand is largely inelastic. Essential imports - fuel, food grains, and industrial raw materials - cannot be easily reduced without disrupting economic activity and welfare. As a result, depreciation tends to raise the import bill in taka terms, even if volumes remain unchanged. This not only fuels inflation but also delays any improvement in the trade balance. In the short run, therefore, depreciation can worsen both inflation and external balances rather than correcting them.
The implication is clear: when inflation is driven by depreciation, exchange rate pass-through becomes counterproductive. Rather than restoring equilibrium, it amplifies instability. The focus of policy must then shift from preserving competitiveness at all costs to breaking the feedback loop between exchange rates and inflation.
Bangladesh Bank’s evolving policy approach reflects this reality. In recent years, the central bank has moved toward a regime of managed flexibility, allowing the exchange rate to adjust to underlying market conditions while intervening to prevent excessive volatility. This approach recognizes that the exchange rate is not merely a relative price but also a key determinant of inflation and financial stability. A purely mechanical adjustment in line with inflation is neither feasible nor desirable in the current context.
Monetary policy has also been tightened to contain inflationary pressures. By moderating liquidity growth and raising policy rates, Bangladesh Bank aims to anchor inflation expectations and prevent second-round effects. However, it is important to acknowledge the limitations of monetary policy in addressing cost-push inflation. When inflation originates from higher import prices, interest rate adjustments alone cannot eliminate the initial shock. They can, however, prevent it from becoming entrenched.
Complementary measures have focused on managing import demand more strategically. Instead of broad-based import compression, which can disrupt production, policy tools such as LC margin requirements have been used selectively to curb non-essential imports while safeguarding critical inputs. This targeted approach helps reduce pressure on the balance of payments without exacerbating supply constraints.
At the same time, strengthening external financing has been crucial. Remittance inflows have remained robust, exceeding USD 30 billion in FY2025, providing a vital cushion to the external account. Export growth has also continued, albeit at a moderate pace of around 7–8 percent. Multilateral and bilateral financing has further supported reserve stabilization. These inflows reduce the need for excessive exchange rate adjustments and help contain depreciation pressures.
Yet, the deeper solution lies in structural transformation. Reducing dependence on imported energy and intermediate goods can significantly mitigate the inflationary impact of depreciation. Expanding domestic production, diversifying exports beyond garments, and increasing value addition are essential to improving the responsiveness of the economy to exchange rate changes. Over time, such reforms can make depreciation a more effective tool for external adjustment without triggering inflationary spirals.
Equally important is the management of expectations. In an environment where businesses and households anticipate continued depreciation, pricing behavior adjusts accordingly, often in advance of actual cost increases. This expectation-driven inflation can be as powerful as the initial shock. Clear communication from Bangladesh Bank, combined with credible and consistent policy actions, is therefore critical to anchoring expectations and stabilizing the economy.
The broader lesson is that exchange rate policy cannot be guided by a single rule. The principle of pass-through in line with inflation is context-dependent. It works when inflation is driven by domestic demand pressures or monetary expansion. But when inflation is itself a consequence of depreciation, the same principle becomes destabilizing. Applying it mechanically can lead to a vicious cycle that undermines both price stability and external balance.
For Bangladesh, the policy priority in the current context is to avoid this trap. Exchange rate flexibility must be maintained, but within a framework that prevents excessive and rapid depreciation. Monetary policy must remain vigilant in anchoring inflation expectations. Import management must be targeted and strategic. And structural reforms must continue to enhance resilience and reduce vulnerability to external shocks. As Bangladesh approaches critical transitions, including LDC graduation and deeper integration into global markets, the need for nuanced macroeconomic management becomes even more pressing. The challenge is not to abandon exchange rate adjustment, but to apply it judiciously, recognizing its interaction with inflation and the broader economy. In conclusion, the conventional wisdom of exchange rate pass-through cannot be applied indiscriminately. When inflation is driven by currency depreciation, further depreciation in response is not a solution - it is part of the problem. A more balanced and context-sensitive policy approach is essential to safeguard macroeconomic stability. For Bangladesh, this means prioritizing stability over mechanical rules, and ensuring that exchange rate policy supports, rather than undermines, the broader objectives of sustainable growth and external resilience.
Mehdi Rahman writes
on foreign trade and
monetary policies.
