A reader of My View on popular fallacies of currency appreciation published in the previous few weeks has directed a series of questions to me. What is Central Bank’s mandate? Should it just target to stabilise the domestic prices? Or should it try to maintain stability in the exchange rate? Or should it work for ensuring a higher economic growth?
These are the general questions which ordinary members of the public ask themselves relating to the Central Bank. Everyone holds answers to these questions according to his or her convenience. Hence, if one asks these questions from 100 people, it is likely that he would get more than 100 different answers.
The writer thought of answering these questions, drawing facts from an article he wrote several years ago.
Economic and price stability is the Central Bank’s mandate
The Central Bank’s mandate is to pursue ‘economic and price stability’ as one of its core objectives. This new mandate was given to the Bank by an amendment to its governing law, Monetary Law Act, in 2002.
This is somewhat a departure from the central banks in the rest of the world which have been mandated to attain only ‘price stability’. Hence, it may be puzzling to many whether the Central Bank of Sri Lanka has been given an additional objective to attain.
The amendment to the Monetary Law came as a part of the modernisation program which the Bank commenced in 2000. One of the essential ingredients of that programme was to update the Monetary Law to be on par with the emerging global best practices relating to central banking.
Up to that time, the Central Bank had been entrusted with a multitude of objectives: attaining domestic price stability, participating in economic development, preserving the external value of the Rupee, protecting banks from collapse and maintaining the financial system stability etc.
These objectives were not very clear and were often in conflict with each other. They also posed difficulties in monitoring the progress or assessing the success of the Bank. Many critiques had pointed out, and the technical staff too in the Bank had experienced, that the Bank could not succeed in its main task of taming inflation and bringing about price stability, if it was saddled with other tasks that would go against its main objective.
Hence, there emerged a general consensus that the central bank should do only what it can do effectively and not otherwise. That consensus required the Central Bank to pursue a single objective, namely, the attainment of price stability.
Redefining price stability target in a peculiar way
Following this consensus that emerged through the consultative process involved in the modernisation, the technical staff of the Bank proposed an amendment to the Monetary Law by mandating the Bank with the task of attaining two core objectives. They were the attainment of both ‘price stability’ and ‘financial system stability’.
When the draft law was submitted to the then Governor, A.S. Jayawardena, for clearance, he had changed the ‘price stability’ to ‘economic and price stability’. The puzzled and bewildered technical staff flocked to his room seeking a clarification, since it was not in line with the accepted international trend. The writer recalls that even the Resident Representative of the IMF at that time too was puzzled by this seemingly inappropriate mandate being added to the Bank’s objectives.
A.S. Jayawardena’s wisdom
But, Jayawardena, assuming his usual erudite and serious posture, offered a different explanation which had never occurred to the technical staff. The writer recalls him saying “…if you have only price stability, then you would fall into the trap of attempting to stabilise a price index which is not what is meant by price stability, in the context of a central bank. The attainment of price stability for a central bank means elimination of both excess demand and excess supply in the market so that the market is free of potential inflationary or deflationary pressures. Such an equilibrium will help the country to maintain a balance in the balance of payments and thereby stability in the exchange rate.”
At that time, many in the Central Bank, including the present writer, did not fully understand the wisdom enshrined in that statement. It even led to the confusion of many that the Bank had been mandated to stabilise the growth rate as well, in addition to the stabilisation of prices. Accordingly, some even charged that the Bank had failed in its tasks, when there was a negative growth in the economy in 2001.
In hindsight, it can now be discerned that Jayawardena’s wisdom was to present the price stability in its totality in clear terms so that the future central bankers would not try to address only a sub part of the issue, namely, rising consumer price indexes.
The true meaning of economic and price stability
We could illustrate this point as follows:
An economy produces goods and services, numbering billions, for use by its members. The total of these goods and services, when they are offered in the market, is called the aggregate supply. This aggregate supply consists of real goods and services which the users can consume or use as inputs for further production. Hence, it is known as a real quantity, quite distinct from an imagined or assumed quantity.
For instance, a coconut is a real quantity, while saying that its value is Rs. 5 or Rs. 10 or any other value is an assumed or an imagined quantity. This real quantity has to be exchanged among members of the society.
Since it is practically impossible to trade one commodity for another commodity in a modern complex economy, there arises the need for adopting a common medium of exchange. ‘Money’ offers the service of this common medium of exchange at the cheapest cost to conclude billions of transactions without a hindrance.
Money values are simply imagined or assumed values
Money, unlike real commodities, is a peculiar animal. Its usefulness arises from its ability to acquire real goods and services which people can enjoy. For instance, I accept my salary in money, because that bundle of money enables me to acquire the rice I want to eat.
If money does not have this ability, no one would be interested in having money. Hence, the value given to money is simply an imaginary value. As a result, money bears a nominal feature, as against the real feature borne by other goods and services. That is why any value measured in terms of money is also known as a nominal value.
How does money work?
We may illustrate the role played by money in an economy by considering the operation of a simple economy where there are only two commodities, say, coconuts and money. Everybody has to use money to get coconuts or use coconuts to get money so as to store their wealth (for getting coconuts in the future).
Suppose there were 10 coconuts and 100 units of money. Then, each coconut has to be exchanged for 10 units of money per coconut. Now, suppose, through a miracle, the money endowment of people doubles to 200 units, while the number of coconuts remains unchanged at 10. Then, the price of coconuts in terms of money rises to 20 units from the earlier 10 units. What has happened here is that when the amount of money doubled, while the production of coconuts had remained unchanged, the prices too have doubled.
What would happen to the price level, if the number of coconuts too doubled along with the doubling of money? Then, 20 coconuts would be exchanged for 200 units of money. Hence, the price level would remain unchanged at 10 units of money per coconut.
Now, suppose that the number of coconuts doubles to 20, while the amount of money remains at 100 units. In this case, the price level has to fall from 10 units of money to 5 units of money.
Let’s consider one more possibility. Suppose that there has been a devastating hurricane and it destroys exactly a half of the original number of coconuts, leaving the balance half intact for use by people.
Now, in this economy, there are only five coconuts against 100 units of money. It is not difficult to discern that the prices would rise to 20 units of money per coconut. What would happen if the amount of money too is raised to 200 units in this scenario? Then, the price of coconut would skyrocket to 40 units of money.
The moral of the example
In the above example, coconut constituting a real output represented the aggregate supply of goods and services, measured in real terms. The total amount of money in the hands of the people represented the demand for coconuts.
Since the money value of coconuts is an imaginary concept, that demand could be described as the nominal aggregate demand for goods and services. What would happen to the general price level will depend on the interplay of these two demand and supply forces.
The rest of the analysis follows the normal microeconomic theory. If the aggregate demand is higher than the aggregate supply, there will be an excess demand in the economy. That excess demand will generate pressure for the general price level to rise.
Similarly, if the aggregate supply is higher than the aggregate demand, the resultant excess supply will put pressure for the prices to fall. Then, it follows that, if someone desires to have price stability, he should try to equate the nominal aggregate demand with the given real aggregate supply.
Keeping excess demand or excess supply at zero level
The price stability, in the context of a central bank, means the maintenance of a zero excess demand or excess supply in the total economy, commonly known as the macro economy. In that situation, all incentives for prices to rise or fall are non-existent.
What is meant by economic stability in the broad objective of the Central Bank is the attainment and maintenance of this state. A central bank cannot be complacent until it has attained this level of stability.
The way to attain that level of stability is to control the nominal aggregate demand by controlling the main force affecting that aggregate demand: the quantity of money in the hands of people. This is because in the long run, the general price level moves exactly in accordance with the movement of money supply. It led the Noble Laureate Milton Friedman to remark in his Noble Laureate Oration that “inflation is always and everywhere a monetary phenomenon”.
The manifestations of excess demand or excess supply
There are three manifestations of an excess demand or an excess supply.
First, people on average make high inflation expectations about the future and use that high inflation in all the negotiations they make with other parties. A good example is trade unions asking a higher wage increase from employers.
Second, the consumer price index starts showing some volatility in its change or stubbornness when it comes to falling below a given level, say 7 or 8 % per annum.
Third, the exchange rate comes under pressure for depreciation on account of a chronic shortage of foreign exchange earned through normal commercial transactions. The country may, accordingly, experience deficits on a continuous basis in its current account of the balance of payments.
Low growth in a consumer price index is no reason for complacence
The presence of any one of these situations requires a central bank to go into action. This means that, even if the consumer price index shows stability or a relatively low growth, the central bank cannot remain idle if other manifestations are present. There, a central bank should try to eradicate the cause instead of pampering with the symptoms.
There appears to be a general tendency for equating increases in the cost of living with inflation. An increase in the cost of living occurs when the basket of commodities consumed by a given group of people entails a higher cost.
As mentioned earlier, this is measured by compiling a consumer price index. A central bank cannot do anything about the increases in the cost of living, since it does not produce goods and services.
That is why John Exter, the founder Governor of the Central Bank, remarked in his very first press interview that “…the Bank does not itself produce goods and services. It will facilitate it by creating right monetary conditions.” Implicit in these ‘right monetary conditions’ is the need for attaining economic and price stability in its totality.
Inflation versus cost of living
Inflation is a much wider phenomenon than the cost of living. It entails the absence of stability in the macro economy leading to an increase in all the prices at the same time. A consumer price index measures the price impact on a consumption basket consisting of only consumer goods.
In contrast, inflation occurs when the prices of all goods, consumption, intermediate, investment and inputs, rise at the same time. It elevates the general price level to a higher level, including those of the consumer goods.
The above misunderstanding may lead to the pitfall of a central banker trying to stabilise the value of a cost of living index through artificial means. It can be attained by fixing price ceilings or granting price subsidies. But, it does not cure the malady of generally rising prices generated by rising nominal aggregate demand over the real aggregate supply.
A subsidy could ease the burden on the cost of living of a given consumer or a group of consumers. But, if the subsidy is financed by incurring a loss elsewhere, it does not help fight inflation. That is because at the place where the loss is incurred, there is a deficit supply that generates pressures for prices to rise.
Similarly, price controls may keep the cost of living index under control. But, as long as there is excess demand in the macro economy, it does not help to contain inflation.
Price trimming is no answer to inflation
The US authorities have recently been criticised on account of a move suggested to stabilise the price index by adopting what is known as ‘trimming of prices’. Under this system, if the price of a given commodity rises by more than 5% in any given month, it has been suggested to remove that commodity from the basket of commodities in the index on the reasoning that consumers would have substituted some other commodity for that commodity.
Such a measure understandably reduces the increase in the price index and the cost of living allowances payable to workers, but it does not eradicate excess demand in the market.
Unintended consequences of supporting a currency against the market forces
As we have shown in previous My Views the pressure for a currency to depreciate is only a symptom of a chronic ailment and the cause of that ailment is the continuous price inflation in the country taxing exporters and subsidising importers. It leads to an excess demand for foreign currencies in the market.
Central banks sometimes resort to addressing the issue by supplying foreign currencies out of its reserves to keep the market demand satisfied misreading the excess demand to be a temporary development.
But it creates a series of unintended consequences bringing further ‘economic instability’ to the economy: the loss of reserves requiring the country to borrow abroad; the creation of domestic liquidity shortages putting upward pressure for interest rates; the central bank’s supply of liquidity to keep interest rates down by printing new money; the generation of further pressures for the currency to depreciate due to higher subsidised imports and higher inflation and the creation of undesired distress in the country’s banking and financial institutions.
So, as shown by the experience of the East Asian countries in 1997, central banks trying to fix economies by adopting short cut methods would eventually get entangled in a serious vicious spiral of moving away from both the economic and price stability and financial sector stability.
It is always advisable for policy makers to learn from the bad experiences of other countries. Just trying to stabilise a price index instead of targeting for an overall balance in the economy will certainly worsen a country’s ailments.
So, the Central Bank of Sri Lanka should always keep in mind that it is mandated not to attain just ‘price stability’, but ‘the economic and price stability’.
(Wijewardena can be reached at firstname.lastname@example.org)