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Money, inflation and output

Reviewed by Saman Kelegama This book was first published in 2010. The second edition, togetherwith the Sinhalese and Tamil versions was released in January 2015 and they are latest addition toeconomic literature in Sri Lanka in the vernacular languages. The basic thesis of the book is ‘goodmoney’ creates wealth and growth while ‘bad money’ would retard this. This observation was made by

Copernicus in 1529 AD and the author shows the validity of this observation in the modern day world.The book has 11 chapters. Some of the chapters explain basic economic concepts in the context ofmonetary policy while others show how monetary policy has worked and the prerequisites for positiveresults. The underlying theme of the book is the need for a Central Bank to conduct independentmonetary policy and thereby keep inflation low, which is essential to achieve higher economic growth. Inflation When too much of money circulation is not matched by an increase in the supply of goods, thegoods prices increase and creates inflation. Inflation inertia is created when past high inflation makes itdifficult to control current and future inflation. When the public is used to a high rate of inflation, theyincorporate high inflation rates to future economic plans – expectation causes the inflation to persist byway of self-fulfilling phenomenon. Thus to combat adverse expectations on inflation, Central Banksmake an effort to sensitise the public on their plans to reduce inflation and provide forecasts of futureinflation levels. Core inflation is the extent of inflation that responds to demand management policies andusually excludes items that are very sensitive to supply side disturbances like food and energy. Headlineinflation on the other hand, is the rate of increase of the price level of all goods and services included inthe consumer basket. A comparison of the two indicators shows that in Sri Lanka, core inflation hasbeen on the decline until late 2007 but headline inflation has been on the increase from mid-2006 to mid-2008. These trends basically show the lagged effect of excessive money printing and the influence of theescalation of food and energy prices, respectively. While presenting these trends, the author has acloser look at the revision of the Consumer Price Index (CPI) in 2007 to replace the outdated basket of

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currencies (based on the 1952 basket) that governed the earlier CPI, and expresses concern of Alcoholreceiving a zero weight, especially when a number of commentators have expressed that Sri Lanka is avery high alcohol consuming nation.

(http://www.ft.lk/ftadmin/wp-content/uploads/2015/02/BUP_DFT_DFT-18-4-L.jpg) Demand for money Demand for money can be explained by the classical framework of the QuantityTheory of Money or Keynesian Framework or Friedman’s framework – it is a complex subject. If demandfor money is stable, a Central Bank can carry out monetary targeting (on the quantity of money) in itsmonetary policy to keep inflation at a low level. In the real world however, the demand for money isunstable. Thus, Central Banks adopt different monetary policy regimes at different times. It is left to theCentral Bank to select the most efficient monetary policy instrument or a combination of instruments toreach the desired credit and money targets. In monetary targeting, a Central Bank cannot directly hitat the final target, i.e., inflation, thus, it aims at operational and intermediate targets. First, the interestrate is used to hit at the operational targets such as high powered money and short-term interest rates.Then high powered money and short-term interest rates impact on the intermediate targets of narrowmoney, broad money, and medium term interest rates. Finally, narrow and broad money and interestrates impact on the aggregate demand and inflation. Central banks use several instruments to conductmonetary policy: interest rates, the statutory reserves, moral suasion, central bank communications, andadministrative instruments (to control aggregate demand). The book shows that the most effective andconvenient instrument is the market based instrument of interest rate. But the market players should besensitive to the interest rates. If the government is a major borrower in the market, and does not changeits demand for credit when changes occur in the interest rates, then monetary policy becomesineffective. "The book is written in very simple language without using mathematical jargon.One need not be an economist to read and understand the book as all key concepts and termsare well explained. The book draws examples from various countries and is not confined to theSri Lankan scenario. It is very clear from the book that the author has a deep understanding of

http://www.ft.lk/ftadmin/wp-content/uploads/2015/02/BUP_DFT_DFT-18-4-L.jpg



central banking and monetary policy. Although he is no longer serving the Central Bank, he hasshared his experience and made a significant contribution to understanding monetary policy.The book will be useful for central bankers, policy makers and economists in Sri Lanka and it isan essential reading for anyone interested in the subject" Chapter 9 highlights the need for propercoordination between monetary authorities and fiscal policy officials to obtain best results from monetarypolicy. When fiscal policy is excessively used and generates high budget deficits, monetary policybecomes accommodative and ineffective, leading to high inflation. Why politicians influence centralbanks and dilute their effectiveness is best captured by quoting the former Governor of the ReserveBank of Australia; first, the tendency to push the economy to run faster than its capacity, and second, thetemptation that governments have to incur budget deficits and fund these by borrowings from the CentralBank. Global economic crisis Chapters 5 and 6 deal with exchange rate management and theglobal economic crisis, respectively. Exchange rate management is closely linked to monetary policy.After heavy loss of international reserves during the 2008/2009 global economic crisis some centralbanks realised that defending the exchange rate (Sri Lanka spent over $ 1 billion to defend the rupee), isnot compatible with independent monetary policy and open capital account – known as the ‘ImpossibleTrinity’ (Sri Lanka had a partially open capital account). Either the Central Bank undertakes adevaluation or approaches a funding agency like the IMF for a loan to boost up the reserves, and therewas no case for resisting both. It is by approaching the IMF in 2009 that Sri Lanka created the space topursue and sustain a more independent and relaxed monetary policy.

(http://www.ft.lk/ftadmin/wp-content/uploads/2015/02/BUP_DFT_DFT-18-2.jpg)In the chapter oneconomic crisis and monetary policy, the author argues that the Central Banks have always been eitherpart of the causes of the crisis or part of the solution to the crisis. He highlights the US experience of theeconomic crisis and how the then Fed Chairman, Alan Greenspan misread the economy and quotesPaul Krugman’s observations on him: “Greenspan’s story is also the story of how makers of economicpolicy convinced themselves that they had everything under control, only to learn, to their horror and the

http://www.ft.lk/ftadmin/wp-content/uploads/2015/02/BUP_DFT_DFT-18-2.jpg



country’s pain – that they did not” (p. 107). Regulation has always lagged behind financial innovation,partly because financial innovation takes place at a rapid pace and partly because of the belief thatfinancial markets are self-correcting. But when regulation is introduced especially after a financial crisis,it may be an interim measure which needs to be continuously updated to face the challenges of financialinnovations. In regard to regulatory responses, the author highlights the shortcomings of Basel I and IIand goes on to say “After resolution of the current crisis, international regulators, no doubt will introduceBasel III, and will fine tune it until the world is hit by a brand new crisis.” (p. 124). Effective monetarypolicy Chapter 7 is perhaps the most important chapter in the book where the key theme is addressed.While money eliminates the cost of searching associated with the barter system (discussed in Chapter1), excessive money growth does not cause any changes in the long run growth of the economy. Thisphenomenon is called ‘neutrality of money’. Excessive monetary growth unless matched by equivalentincrease in the supply of goods, will generate inflation. Highlighting the existing literature, the bookshows that an inflation level of about 2% is the best to achieve high growth rates – completely dismissingan assertion by some commentators that having a little bit of inflation is like being a little bit pregnant thatwill grow to an uncontrollable level. In Chapter 8, the author discusses inflation targeting (IT) andargues that “successful implementation of IT requires a country to meet several prerequisites: a maturefinancial system, monetary policy independence, fiscal discipline and transparency, accountability andgood governance in the Central Bank” (p. 157). Due to the instability of the demand for money, manycentral banks have abandoned the monetary targeting framework in favour of IT. New Zealandpioneered IT and their strategy was that if the expected inflation was not realised, the Governor of theCentral Bank would resign unless he could provide an explanation acceptable to the Parliament. Manycountries (Canada, Australia, Chile, South Korea, Mexico, Israel, etc.) today use IT as a policy to bringdown inflation. Sri Lanka (by 2010) is yet to create conditions for IT, although the subject has beendiscussed extensively. However, given the groundwork done so far, the author believes that IT will soonbecome the policy in Sri Lanka. Independence of the Central Bank The 10th Chapter is on theindependence of the Central Bank. The author shows that unlike New Zealand and other inflationtargeting nations, the Central Bank of Sri Lanka is both goal and target independent. Basically, the goalhas to be identified from the broad objectives in the law governing the Monetary Board. The key duties ofthe central bank should be to ensure price stability and financial system stability. Some central banks areentrusted with a large number of other functions unrelated to the key objectives. For instance, theCentral Bank of Sri Lanka is encumbered with management of Government funds – EPF (Employees’Provident Fund) and management of public debt – and these have conflicting interests with the keyobjectives of the bank. “…Central Banks have realised that they do not have instruments and ways andmeans to achieve multiple objectives. The only task they could accomplish well is maintaining pricestability...” (p.19). The independence of the Central Bank of Sri Lanka is then discussed, firsthighlighting that the Central Bank has no legal identity and it is only the Monetary Board that has a legalidentity; thus, what matters is the independence of the Monetary Board. The book highlights four areaswhich have contributed to the dilution of the independence of the Monetary Board: (1) Section 89 of theMonetary Law Act permits the Central Bank to grant provisional advances to the Treasury up to 10% ofthe estimated revenue. In the past, the Treasury has always availed of this facility fully, thus preventingthe Central Bank from controlling this injection of money to the economy, (2) the Central Bank is theagent for the government in raising public debt – thus making it vulnerable to subscribe to the publicdebt, (3) the Central Bank is the banker to the government – thus causing difficulties in controlling



money supply, and (4) the Secretary to the Treasury being a member of the Board (ex-officio) mayinfluence the Board to accommodate the fiscal needs of the political establishment. The book arguesthat the Central Bank should be made independent by law (this was also the recommendation of theFinal Report of the Presidential Commission on Finance and Banking, Vol. II, 1992, pp. 266-267), tomake monetary policy more effective. What should be the attitude of a Central Banker? Alwayspessimistic – always look for risks to the stability of the economy. Quoting another Central BankGovernor, the author argues that this attitude should permeate from bottom to top in a Central Bank:“When my Minister is elated about high economic growth, I worry about overheating of the economy,when he talks about high foreign inflows, I worry about external stability, and when he beams withappreciating currency, I worry about competitiveness of the country” (p. 215-216). Looking beyondThere are a few areas in the book where some questions could be raised. First, in the final chapter, thebook argues the case for a regional Monetary Integration for bringing more binding commitment tomonetary discipline than perhaps an independent Central Bank that will be difficult to create due to thepolitical economy. This idea of course requires harmonising of macroeconomic policies in the region –which would be difficult given the fiscal indiscipline in the regional members of South Asia. Second is there-emergence of Keynesian economic policy after the 2008/2009 global economic crisis where a fiscalstimulus was injected by many countries (that had fiscal space) to rejuvenate their economies, ratherthan sticking to the monetarist doctrine of inaction. The latter is based on the belief that self-adjustmentof the economy is sufficiently fast, while government action may cause undue harmful effects on theeconomy, which could have in any case reach its equilibrium before any government action takes effect.The rapid global recovery with fiscal stimulus shows that the Keynesian formula has worked withreasonable control over inflation. The book says: “…when governments resort to Keynesian policies ofactive engagement, countries may recover, but may cause other long-term problems of high budgetdeficits and high debt levels” (p. 121). The author presents the case where the monetary formula didnot work when Japan was on a ‘liquidity trap’ in the 1990s and how it resorted to a fiscal stimulus torevive the economy resulting in budget deficits. This issue needs elaboration and Paul Krugmanadvocated a 4% GDP fiscal stimulus package to the US economy instead of the 1% GDP stimuluspackage of the Obama administration in 2010. Krugman believes that at a time when credit markets arefrozen, producers are closing factories, and consumers are not spending, there are unused resourcesthat could be put into effective work via a Keynesian stimulus and argues that any adverseconsequences of such a policy could be effectively managed (see The Return of Depression Economicsand the Crisis of 2008 by Paul Krugman, Norton, 2008). This area should have received more attentionin the book where better harmony could be worked out between fiscal policy and monetaryaccommodation to minimise the adverse consequences of a fiscal stimulus after a crisis. ReflectionsThe book is written in very simple language without using mathematical jargon. One need not be aneconomist to read and understand the book as all key concepts and terms are well explained. The bookdraws examples from various countries and is not confined to the Sri Lankan scenario. It is very clearfrom the book that the author has a deep understanding of central banking and monetary policy.Although he is no longer serving the Central Bank, he has shared his experience and made a significantcontribution to understanding monetary policy. The book will be useful for central bankers, policy makersand economists in Sri Lanka and it is an essential reading for anyone interested in the subject. Reviewedby Saman Kelegama This book was first published in 2010. The second edition, together with theSinhalese and Tamil versions was released in January 2015 and they are latest addition to economic



literature in Sri Lanka in the vernacular languages. The basic thesis of the book is ‘good money’ createswealth and growth while ‘bad money’ would retard this. This observation was made by Copernicus in1529 AD and the author shows the validity of this observation in the modern day world. The book has 11chapters. Some of the chapters explain basic economic concepts in the context of monetary policy whileothers show how monetary policy has worked and the prerequisites for positive results. The underlyingtheme of the book is the need for a Central Bank to conduct independent monetary policy and therebykeep inflation low, which is essential to achieve higher economic growth. Inflation When too much ofmoney circulation is not matched by an increase in the supply of goods, the goods prices increase andcreates inflation. Inflation inertia is created when past high inflation makes it difficult to control currentand future inflation. When the public is used to a high rate of inflation, they incorporate high inflationrates to future economic plans – expectation causes the inflation to persist by way of self-fulfillingphenomenon. Thus to combat adverse expectations on inflation, Central Banks make an effort tosensitise the public on their plans to reduce inflation and provide forecasts of future inflation levels. Coreinflation is the extent of inflation that responds to demand management policies and usually excludesitems that are very sensitive to supply side disturbances like food and energy. Headline inflation on theother hand, is the rate of increase of the price level of all goods and services included in the consumerbasket. A comparison of the two indicators shows that in Sri Lanka, core inflation has been on thedecline until late 2007 but headline inflation has been on the increase from mid-2006 to mid-2008. Thesetrends basically show the lagged effect of excessive money printing and the influence of the escalationof food and energy prices, respectively. While presenting these trends, the author has a closer look atthe revision of the Consumer Price Index (CPI) in 2007 to replace the outdated basket of currencies(based on the 1952 basket) that governed the earlier CPI, and expresses concern of Alcohol receiving azero weight, especially when a number of commentators have expressed that Sri Lanka is a very highalcohol consuming nation. Demand for money Demand for money can be explained by the classicalframework of the Quantity Theory of Money or Keynesian Framework or Friedman’s framework – it is acomplex subject. If demand for money is stable, a Central Bank can carry out monetary targeting (on thequantity of money) in its monetary policy to keep inflation at a low level. In the real world however, thedemand for money is unstable. Thus, Central Banks adopt different monetary policy regimes at differenttimes. It is left to the Central Bank to select the most efficient monetary policy instrument or acombination of instruments to reach the desired credit and money targets. In monetary targeting, aCentral Bank cannot directly hit at the final target, i.e., inflation, thus, it aims at operational andintermediate targets. First, the interest rate is used to hit at the operational targets such as high poweredmoney and short-term interest rates. Then high powered money and short-term interest rates impact onthe intermediate targets of narrow money, broad money, and medium term interest rates. Finally, narrowand broad money and interest rates impact on the aggregate demand and inflation. Central banks useseveral instruments to conduct monetary policy: interest rates, the statutory reserves, moral suasion,central bank communications, and administrative instruments (to control aggregate demand). The bookshows that the most effective and convenient instrument is the market based instrument of interest rate.But the market players should be sensitive to the interest rates. If the government is a major borrower inthe market, and does not change its demand for credit when changes occur in the interest rates, thenmonetary policy becomes ineffective. Chapter 9 highlights the need for proper coordination betweenmonetary authorities and fiscal policy officials to obtain best results from monetary policy. When fiscalpolicy is excessively used and generates high budget deficits, monetary policy becomes accommodative



and ineffective, leading to high inflation. Why politicians influence central banks and dilute theireffectiveness is best captured by quoting the former Governor of the Reserve Bank of Australia; first, thetendency to push the economy to run faster than its capacity, and second, the temptation thatgovernments have to incur budget deficits and fund these by borrowings from the Central Bank. Globaleconomic crisis Chapters 5 and 6 deal with exchange rate management and the global economic crisis,respectively. Exchange rate management is closely linked to monetary policy. After heavy loss ofinternational reserves during the 2008/2009 global economic crisis some central banks realised thatdefending the exchange rate (Sri Lanka spent over $ 1 billion to defend the rupee), is not compatiblewith independent monetary policy and open capital account – known as the ‘Impossible Trinity’ (SriLanka had a partially open capital account). Either the Central Bank undertakes a devaluation orapproaches a funding agency like the IMF for a loan to boost up the reserves, and there was no case forresisting both. It is by approaching the IMF in 2009 that Sri Lanka created the space to pursue andsustain a more independent and relaxed monetary policy. In the chapter on economic crisis andmonetary policy, the author argues that the Central Banks have always been either part of the causes ofthe crisis or part of the solution to the crisis. He highlights the US experience of the economic crisis andhow the then Fed Chairman, Alan Greenspan misread the economy and quotes Paul Krugman’sobservations on him: “Greenspan’s story is also the story of how makers of economic policy convincedthemselves that they had everything under control, only to learn, to their horror and the country’s pain –that they did not” (p. 107). Regulation has always lagged behind financial innovation, partly becausefinancial innovation takes place at a rapid pace and partly because of the belief that financial marketsare self-correcting. But when regulation is introduced especially after a financial crisis, it may be aninterim measure which needs to be continuously updated to face the challenges of financial innovations.In regard to regulatory responses, the author highlights the shortcomings of Basel I and II and goes on tosay “After resolution of the current crisis, international regulators, no doubt will introduce Basel III, andwill fine tune it until the world is hit by a brand new crisis.” (p. 124). Effective monetary policy Chapter 7is perhaps the most important chapter in the book where the key theme is addressed. While moneyeliminates the cost of searching associated with the barter system (discussed in Chapter 1), excessivemoney growth does not cause any changes in the long run growth of the economy. This phenomenon iscalled ‘neutrality of money’. Excessive monetary growth unless matched by equivalent increase in thesupply of goods, will generate inflation. Highlighting the existing literature, the book shows that aninflation level of about 2% is the best to achieve high growth rates – completely dismissing an assertionby some commentators that having a little bit of inflation is like being a little bit pregnant that will grow toan uncontrollable level. In Chapter 8, the author discusses inflation targeting (IT) and argues that“successful implementation of IT requires a country to meet several prerequisites: a mature financialsystem, monetary policy independence, fiscal discipline and transparency, accountability and goodgovernance in the Central Bank” (p. 157). Due to the instability of the demand for money, many centralbanks have abandoned the monetary targeting framework in favour of IT. New Zealand pioneered IT andtheir strategy was that if the expected inflation was not realised, the Governor of the Central Bank wouldresign unless he could provide an explanation acceptable to the Parliament. Many countries (Canada,Australia, Chile, South Korea, Mexico, Israel, etc.) today use IT as a policy to bring down inflation. SriLanka (by 2010) is yet to create conditions for IT, although the subject has been discussed extensively.However, given the groundwork done so far, the author believes that IT will soon become the policy inSri Lanka. Independence of the Central Bank The 10th Chapter is on the independence of the Central



Bank. The author shows that unlike New Zealand and other inflation targeting nations, the Central Bankof Sri Lanka is both goal and target independent. Basically, the goal has to be identified from the broadobjectives in the law governing the Monetary Board. The key duties of the central bank should be toensure price stability and financial system stability. Some central banks are entrusted with a largenumber of other functions unrelated to the key objectives. For instance, the Central Bank of Sri Lanka isencumbered with management of Government funds – EPF (Employees’ Provident Fund) andmanagement of public debt – and these have conflicting interests with the key objectives of the bank. “…Central Banks have realised that they do not have instruments and ways and means to achieve multipleobjectives. The only task they could accomplish well is maintaining price stability...” (p.19). Theindependence of the Central Bank of Sri Lanka is then discussed, first highlighting that the Central Bankhas no legal identity and it is only the Monetary Board that has a legal identity; thus, what matters is theindependence of the Monetary Board. The book highlights four areas which have contributed to thedilution of the independence of the Monetary Board: (1) Section 89 of the Monetary Law Act permits theCentral Bank to grant provisional advances to the Treasury up to 10% of the estimated revenue. In thepast, the Treasury has always availed of this facility fully, thus preventing the Central Bank fromcontrolling this injection of money to the economy, (2) the Central Bank is the agent for the governmentin raising public debt – thus making it vulnerable to subscribe to the public debt, (3) the Central Bank isthe banker to the government – thus causing difficulties in controlling money supply, and (4) theSecretary to the Treasury being a member of the Board (ex-officio) may influence the Board toaccommodate the fiscal needs of the political establishment. The book argues that the Central Bankshould be made independent by law (this was also the recommendation of the Final Report of thePresidential Commission on Finance and Banking, Vol. II, 1992, pp. 266-267), to make monetary policymore effective. What should be the attitude of a Central Banker? Always pessimistic – always look forrisks to the stability of the economy. Quoting another Central Bank Governor, the author argues that thisattitude should permeate from bottom to top in a Central Bank: “When my Minister is elated about higheconomic growth, I worry about overheating of the economy, when he talks about high foreign inflows, Iworry about external stability, and when he beams with appreciating currency, I worry aboutcompetitiveness of the country” (p. 215-216). Looking beyond There are a few areas in the book wheresome questions could be raised. First, in the final chapter, the book argues the case for a regionalMonetary Integration for bringing more binding commitment to monetary discipline than perhaps anindependent Central Bank that will be difficult to create due to the political economy. This idea of courserequires harmonising of macroeconomic policies in the region – which would be difficult given the fiscalindiscipline in the regional members of South Asia. Second is the re-emergence of Keynesian economicpolicy after the 2008/2009 global economic crisis where a fiscal stimulus was injected by many countries(that had fiscal space) to rejuvenate their economies, rather than sticking to the monetarist doctrine ofinaction. The latter is based on the belief that self-adjustment of the economy is sufficiently fast, whilegovernment action may cause undue harmful effects on the economy, which could have in any casereach its equilibrium before any government action takes effect. The rapid global recovery with fiscalstimulus shows that the Keynesian formula has worked with reasonable control over inflation. The booksays: “…when governments resort to Keynesian policies of active engagement, countries may recover,but may cause other long-term problems of high budget deficits and high debt levels” (p. 121). Theauthor presents the case where the monetary formula did not work when Japan was on a ‘liquidity trap’in the 1990s and how it resorted to a fiscal stimulus to revive the economy resulting in budget deficits.



This issue needs elaboration and Paul Krugman advocated a 4% GDP fiscal stimulus package to the USeconomy instead of the 1% GDP stimulus package of the Obama administration in 2010. Krugmanbelieves that at a time when credit markets are frozen, producers are closing factories, and consumersare not spending, there are unused resources that could be put into effective work via a Keynesianstimulus and argues that any adverse consequences of such a policy could be effectively managed (seeThe Return of Depression Economics and the Crisis of 2008 by Paul Krugman, Norton, 2008). This areashould have received more attention in the book where better harmony could be worked out betweenfiscal policy and monetary accommodation to minimise the adverse consequences of a fiscal stimulusafter a crisis. Reflections The book is written in very simple language without using mathematical jargon.One need not be an economist to read and understand the book as all key concepts and terms are wellexplained. The book draws examples from various countries and is not confined to the Sri Lankanscenario. It is very clear from the book that the author has a deep understanding of central banking andmonetary policy. Although he is no longer serving the Central Bank, he has shared his experience andmade a significant contribution to understanding monetary policy. The book will be useful for centralbankers, policy makers and economists in Sri Lanka and it is an essential reading for anyone interestedin the subject.

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money, inflation and output · inflation levels. core inflation is the extent of inflation that...

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