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There is no argument on the economics and thinking of the Central Bank to adopt an expansionary monetary policy stance at a time of moderate level of inflation according to mainstream economic notions. The expected overall outcome of the Central Bank, i.e. mainly to stimulating the economy through these measures, should be appreciated and welcome.
However, it is worth digging a little further to see whether these monetary policy measures will bring the expected results in real terms? Or what are the arguments for not stimulating the economy as expected by the monetary policy easing? Whether the policy impact on real economy would be today, tomorrow or never?
Rational expectation
Though this slightly carries away the reader from the main thrust of the article, the story of ex-wife of Prof. Robert Lucas Jnr. who won the Nobel Prize in 1995 would be a sensible starting point for us to think beyond what Keynesians and Monetarists were told on monetary policy transmission mechanism in an economy.
Rita Lucas filed her divorce papers from Prof. Lucas in 1988 and one of the clauses in the divorce papers was that if Prof. Lucas happened to receive a Nobel Prize within seven years of their divorce, she would be entitled to half of the prize money. She got divorced in 1988 and Prof. Lucas won the Nobel Prize in 1995.
After receiving his Nobel Prize Lucas had to honour his commitment toward his ex-wife, paying half of his Nobel Prize money, which could have been avoided easily if he had got it a few months later. Quite an interesting story!
We have a few things to take from this story. The first one: We should never ask for a divorce from a wife of Rita Lucas’ calibre! Secondly, how important is the theory of rational expectation presented by Nobel Laurite Prof. Robert Lucas and ironically application of the theory (knowingly or unknowingly) by his ex wife?
Coming back to the basics, the rational expectation theory presented by Prof. Robert Lucas, a Chicago economist, has later resulted in analysing government policy measures through a different perspective.
The rational expectation theory, in its simplest meaning, tells that the economic agents are capable of predicting to a greater extent the expected outcome of government policy before hand and adjusting themselves by negating the expected outcome perceived by the policy authorities.
By exercising rational expectation against the adaptive expectation relying on past data, people will use all available information to formulate expectations of economic variables such as inflation, interest, money supply, etc. Individuals have strong incentives to make rational forecasts and to act accordingly.
Therefore, in the Sri Lankan scenario, increasing expected inflation extrapolated with past data as well as current upward price increases in sensitive areas such as energy and global economic issues coupled with a series of expansionary monetary policy measures may lead to a rational conclusion of economic agents that the Central Bank will eventually engage in restrictive monetary policy to reduce inflationary pressure sooner than later.
These rational expectations of an economy, in this case, agents operating in the Sri Lankan economy, may play a significant role towards the outcome of the monetary policy implemented by the Central Bank.
The inflationary expectations of Sri Lanka may result in entering into wage agreements and upward price movements and determine the shape of (reduce) the aggregate supply of the economy due to increase in supply side cost.
Therefore, there is a scope that rational expectations combined with flexible prices and wages may negate the anticipated monetary policy objectives and may not impact on economic activity as expected by the Central Bank.
Policy ineffective proposition
In 1976, based on the theory of rational expectation, two American economists, Thomas J. Sargent and Neil Wallace, directly proposed that monetary policy could not systematically manage the levels of output and employment in the economy.
When applying rational expectations within a macroeconomic framework, Sargent and Wallace produced the policy-ineffectiveness proposition, according to which the government could not successfully intervene in the economy, if attempting to manipulate output.
If the government employed monetary expansion in order to increase output, agents would foresee the effects and wage and price expectations would be revised upwards accordingly. This results in real wages remaining constant and therefore so do output and growth.
Policy lag and transmission mechanism
This is the area where the Central Bank may have to rethink its approach as rational expectation and policy ineffectiveness proposition happen largely outside the Central Bank domain.
As indicated at the beginning, within a six-week timeframe, the Central Bank has taken three measures towards easing the money supply of the Sri Lankan economy. What impact one can make on the economy within six weeks?
Policy time lags occur between the onset of an economic problem and the full impact of the policy intended to correct the problem through policy transmission mechanism. Basically, policy lags consists of inside lag – the time taken to getting the policy activated – and outside lag – the subsequent impact of the policy on real variables.
Policy lags arise because government actions are not instantaneous. The use of any stabilisation policy encounters time lags between the beginning of an economic problem, such as a business-cycle contraction or the starting of inflation, and the full impact of the policy designed to correct the problem. For example, should a business-cycle contraction hit the economy on 1 January, stabilisation policy cannot correct the problem by 2 January. The use of any stabilisation policy, especially fiscal policy and monetary policy, takes time to work through the system. Inside lags are likely to take several months. In this case it is the Central Bank, which knows the inside lag it experienced prior to implementation of the policies concerned. According to theoretical literature, a best case scenario involves at least two months. One month to recognise the problem and another month to select and implement the appropriation policy. However, a more likely scenario as per the experts would be three to six months of inside lags.
The outside lag is the time it takes after a policy is selected and implemented by appropriate government entities, before it works its magic on the economy. Such magic is not instantaneous. This lag is the time it takes any change initiated by a government policy to impact the producers and consumers in the economy.
A key part of the impact lag is the multiplier. An initial change in government spending, taxes, the money supply, interest rates must work through the economy, triggering changes in production and income, which induces changes in consumption, which causes more changes in production and income, which induces further changes in consumption.
Each ‘round’ of changes is likely to take a month or two. Several rounds are needed (six to 10 or more) before the bulk of this impact is realised in the visible economy. An impact lag of one to two years is not uncommon. Obviously, it is impractical to expect changes to real economy within weeks after the policy implementation, whether we like it or not.
Conclusion
Despite the criticisms on above explanations, as well as the sound economic explanation on stimulating the economy by way of expansionary monetary policy as explained under mainstream economic domain, one cannot grossly overlook the possibility of those disturbances to the same sound explanations and actions due to the operation of other theoretical bases, some of which have already been indicated above.
The series of monetary policy measures introduced by the Central Bank may therefore impact on the economy today or tomorrow or never have an impact at all!
(The writer holds a B.Sc Degree from the University of Sri Jayawaradanapura, and has completed a Postgraduate Diploma in Economic Development at the University of Colombo. He can be reached via [email protected].)
