W A Wijewardena: Central Bank - why "economic and price stability"?
Speech by Mr W A Wijewardena, Deputy Governor of the Central Bank of Sri Lanka, at the
Association of Professional Bankers, Colombo, 23 March 2007.
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An amendment effected to the Monetary Law Act in 2002 requires the Central Bank of Sri Lanka to
pursue "economic and price stability" as one of the two core objectives of the Bank. 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. It is, therefore, timely to identify the precise meaning
of this phrase "economic and price stability" in the context of a central bank.
The amendment to the Monetary Law came as a part of the modernization program which the Bank
commenced in 2000. One of the essential ingredients of that program was to update the Monetary
Law to be on par with the emerging global best practices. Up to that time, the Central Bank had been
entrusted with a multitude of objectives: attaining price stability, participating in economic
development, preserving the external value of 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. Many
critiques had pointed out, and the technical staff 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, viz., the attainment of price stability.
Following this consensus that emerged through the consultative process involved in the
modernization, 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,
Mr. A. S Jayawardena, for clearance, he had changed the "price stability" to "economic and price
stability". The puzzled and bewildered technical staff flocked into 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 too was puzzled by this seemingly inappropriate mandate being added to
the Bank's objectives.
But, Mr. Jayawardena, assuming his usual erudite and serious posture, offered a different explanation
which had never occur red 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 stabilize 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"
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 confusion by many that the Bank had been
mandated to stabilize the growth rate as well, in addition to the stabilization 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 Mr. Jayawardena's wisdom was to
present the price stability in its totality rather than as a sub part of the issue.
We could illustrate this point as follows:
An economy produces goods and services, numbering millions, 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. 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. offers the service of this
"Money"
common medium of exchange at the cheapest cost to conclude the transactions running into billions.
Money, unlike the real commodities, is a peculiar animal. Its usefulness arises from its ability to
acquire real goods and services which people can enjoy. 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.
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 merciful 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 5 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.
What was considered here was a very simple economy for ease of clarity. But, the broad results
derived are equally valid to a modern economy with billions of transactions. These results can be
summarized as follows:
First, if the money supply increases, while the output remains unchanged, then, the general price level
will tend to increase.
Second, if the money supply increases at the same rate as the increase in the output, then the
general price level remains unchanged.
Third, if the money supply does not increase, when the output has increased, then, the general price
level will fall.
Fourth, if the money supply has remained unchanged or even raised when the output has fallen (a
negative supply shock), then the prices would rise to a still higher level.
In the above example, coconut constituting 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.
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".
What are the manifestations of the absence of that level of stability? There are two manifestations.
First, people on average may not expect the general price level to remain stable in the future. They
make that expectation by considering the past trends and what is happening right now. If they expect
that the prices on average would rise, then, they can be said to be harboring high inflation
expectations. A central bank can gauge this situation by conducting periodical inflation expectation
surveys.
Second, a consumer price index, compiled to measure the changes in the cost of living of a given
group of people, may show a continuous increase over a substantial period of time. It indicates an
unstable situation in the macro economy leading to an upward movement in the general price level.
The presence of either situation requires a central bank to go into action against fighting inflation. This
means that, even if the consumer price index shows stability or a relatively low growth, the central
bank cannot stop taking inflation fighting measures. What a central bank should do is to eradicate the
cause rather than pampering with the symptoms. It is similar to a physician who does not take delight
when he observes that the high fever of a patient has subsided. The physician would not stop his
curative treatment, until the cause of that high fever is totally eliminated.
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 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 stabilize 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 to fight inflation. That is because at the place where the loss is incurred,
there exists a deficit supply creating 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.
Then, what about negative supply shocks such as a temporary fall in the output of agricultural
products or increases in the prices of imported goods? They would reduce the real aggregate supply
creating an excess demand in the macro economy. It would lead to the increase in the prices of
certain consumer goods raising the cost of living of those who consume them. But, that is not inflation.
For these one-off events to become inflation, the nominal aggregate demand should also rise
continuously over the real aggregate supply. In other words, the macro economy should be
characterized by the presence of an excess demand for goods and services. The elimination of this
excess demand is the path for curing the malady of inflation.
When there is no excess demand or excess supply, then, the macro economy is said to be in balance.
Such a balance eliminates the pressure on prices to change. The public having observed the general
stability in the overall price level would form low expectations on future changes in the prices. This
would lead to future price stability as well. For this to happen, all sources of increasing money in the
hands of people should be constantly kept under control. This is the wisdom enshrined in "economic
and price stability".