Download Money Printing and Inflation

MONEY PRINTING AND INFLATION

Background
It has been observed that several articles and news items were published
in media raising allegations against certain Central Bank activities,
particularly money printing. These allegations highlight two main facts.
First, the Central Bank has resorted to “irresponsible wide scale money
printing to finance the fiscal deficit of the Government.” Second, “the
excessive money printing has fuelled high and persistent inflation
causing serious threats to the socio-economic stability of the country”.
The Central Bank of Sri Lanka (CBSL) has issued several press releases
elaborating the process of printing money and the actual developments
during the recent period. CBSL has made such attempts considering the
“adverse impact that could be felt by the economy due to the generation
of such negative sentiments as a result of these myths and
misperceptions”. However, it has been noticed that some analysts
continue to claim the same argument despite the CBSL’s explanations on
the issue.
In this background, it is intended to examine the issue with a detailed
explanation for the benefit of the economic agents and stakeholders
including entrepreneurs, investors, academics, general public and
specially students. Accordingly, this article reviews the monetary policy
framework of CBSL, the process of money printing, relationship between
inflation and net credit to the government and the recent developments
in money and inflation.

The Mandate and the Monetary Policy Framework of the Central
Bank of Sri Lanka
All over the world, maintaining price stability has become the
over-riding objective of Central Banks. In such context, maintaining
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economic and price stability has become one of the core objectives of
CBSL.
Price stability is a situation where there are no wide fluctuations in the
general price level in an economy, which leads to achieving sustainable
economic growth. Stable prices would not distort economic decisions,
thus enabling efficient allocation of resources in the economy. A Central
Bank formulates and implements its monetary policy, i.e. actions to
influence cost and availability of money, to attain this objective.
At present, the monetary policy framework of CBSL is based on a
monetary targeting framework. In this framework, the final target, price
stability, is to be achieved by influencing changes in broad money supply
which is linked to reserve money through a multiplier. Accordingly,
reserve money, i.e. new money injected to the economy, serves as the
operating target while the broad money, i.e. the total stock of money
generated through the multiplier process serves as the intermediate
target of monetary policy.
This monetary targeting framework is operated through a monetary
programme. The monetary programme is prepared by the Central Bank
taking into account developments and projections in economic factors
such as the expected fiscal and balance of payments developments,
economic growth, desired levels of growth in credit and inflation. Based
on these factors, the monetary programme sets out the desired path for
monetary growth and determines the path of quarterly reserve money
targets necessary to achieve this monetary growth. Targets are designed
to ensure that the Central Bank releases reserve money that supports to
facilitate a growing flow of transactions.
CBSL is equipped with a wide range of instruments for monetary
management. Recently, more emphasis has been placed on conducting
Open Market Operations aggressively while placing some limits on the
access of commercial banks to the funds from the Central Bank to meet
their liquidity needs. This has also been supported by policy interest
rates.
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
Money Printing
Usually, the Central Bank or the monetary authority is solely responsible
for printing money, which means releasing fresh money to the economy.
In Sri Lanka, CBSL is the primary source of money supply and therefore
is solely responsible for issuing new money to the economy. Although
the Central Bank has a stock of minted coins and printed currency notes
in its vaults to be issued as money, they do not become money until such
time they are possessed by the public as assets.
Precisely, printing money can be correctly explained as releasing money
into circulation by the Central Bank and this is done entirely based on
fundamental reasons. The fresh money issued by the Central Bank is
called reserve money. This is called “reserve”, “base” or “high-powered”
money as commercial banks can create deposits based on reserve money,
which are components of the broader definition of money supply,
through their process of creating credit and deposits.
Reserve money consists of currency issued by the Central Bank,
commercial banks’ deposits and government agencies’ deposits with the
Central Bank. These are liabilities of the Central Bank and are shown
under the liability side of the Central Bank balance sheet. As per
accounting fundamentals, these have to be backed by the assets of the
Central Bank balance sheet.
There are two main channels of releasing reserve money from the Central
Bank to the economy, i.e. by acquiring domestic assets and foreign assets.
The acquisition of domestic assets by the Central Bank takes place
through lending to the government and/or commercial banks. One way
of government borrowing is selling its Treasury bills to the Central Bank.
Also, according to the Monetary Law Act the government can obtain an
amount equivalent to 10 per cent of its estimated annual revenue as
provisional advances from the Central Bank. Accordingly, there will be
an injection of new money from Central Bank to the economy through
these operations.
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The government also maintains deposits with the Central Bank. The
difference between the borrowings mentioned above and the deposits is
called “net credit to the government (NCG)”. Similarly, money will be
injected to the economy when commercial banks borrow from the
Central Bank or sell domestic assets in their portfolio such as Treasury
bills to the Central Bank. Net credit to the government and commercial
banks by the Central Bank when net-off to the other assets and liabilities
of the Central Bank are called net domestic assets (NDA) of the Central
Bank. NCG is the main component in the NDA of the Central Bank.
The second channel of releasing new money to the economy is
acquisition of foreign assets by the Central Bank. When the Central Bank
purchases foreign exchange from the government or commercial banks it
has to inject new money, which will lead to an expansion in reserve
money and vise versa. Therefore, the net change in foreign assets, which
is called net foreign assets (NFA) of the Central Bank, contributes either
to expand or contract the reserve money.
Each year, the Central Bank sets out its monetary programme based on
the expected developments in all the major sectors in the economy. One
of the main purposes of the monetary programme is to project the
amount of new money that the Central Bank should inject to the
economy in that particular year. Usually, the new money injection should
be sufficient to meet the expected expansion in economic activities. In
other words, it should tally with the nominal growth in gross domestic
product.
The planned injection of money needs to be entirely backed by the
aforementioned increases in NDA and NFA. For any increase in domestic
assets above the expected level, there should be a corresponding decline
in foreign assets, and vise versa in order to meet the planned amount of
new money injection in a particular year.
For example, when the foreign exchange market is highly liquid through
increases in foreign currency inflows, to avoid undue fluctuations in the
exchange rate, the Central Bank would need to purchase foreign currency.
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This leads to an increase in NFA of the Central Bank. Whenever, the
Central Bank purchases foreign currency, an equivalent amount of
rupees will be issued to the system and new money or in other words,
market liquidity, would increase accordingly. If this new money or
liquidity injection is more than the desired level, the Central Bank is
required to conduct open market operations using government securities
from its holdings in order to absorb the excess liquidity and thereby
maintain reserve money at targeted levels. Hence, there will be a
corresponding adjustment in NDA, or more precisely there will be a
reduction in Treasury bill holdings of the Central Bank thereby lowering
the NCG component.
In recent times, some analysts have made attempts to interpret the
increase in NCG as an increase in reserve money. However, it is clear and
obvious that the NCG is only a part of reserve money or new money
injection and increase in NCG alone cannot be interpreted as money
printed by the Central Bank. It is necessary to examine the changes in
both NDA (which include NCG) and NFA in order to have a clear idea
about the amount of new money injected to the economy in a particular
year. A Central Bank’s strategy is to maintain and control the overall
amount of money issued to the economy by looking at the developments
in both NDA and NFA of the Central Bank and not only the component
of NCG.

Money Printing by CBSL in Recent Times
In the recent past, the annual percentage increases in new money had
been set at around 15 per cent per annum while the actual percentage
increases from 2002 to 2007 are set out in Table 1.
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Table 1
Reserve Money Injection in Recent Years
2002
2003
2004
2005
Economic Growth - %
4.0
6.0
5.4
6.0
Inflation – GDP Deflator -%
8.4
5.0
9.3
9.9
Reserve Money
Level – Rs.bn
Growth - %
Sources – Rs.bn
Net Foreign Assets
Net Domestics Assets
o/w NCG
Other Items (net)
2006
7.4
10.3
2007
6.7*
13.7*
126.4
12.3
141.4
11.9
171.0
20.9
197.9
15.8
239.9
21.2
264.4
10.2
117.4
9.0
71.1
-61.9
164.6
-23.1
42.7
-65.3
151.7
19.3
108.7
-88.9
196.9
1.0
75.3
-75.9
229.9
10.0
114.3
-105.4
292.9
-28.5
102.5
-131.7
* Estimate
As shown in the Table, the reserve money growth rates were largely on
par with expected economic growth rates and inflation rates, except 2004
and 2006. The reserve money target for 2007 was set at the stringent
growth rate of 11.7 per cent or, in value terms an increase of Rs. 27.7
billion to Rs. 267.6 billion. However, the actual amount of reserve money
as at end December 2007 was even below at Rs. 264.4 billion and the
increase was entirely due to the increase in NFA. In fact, the actual
reserve money growth during 2007 was at 10.2 per cent, which was even
lower than the tight target set at the beginning of the year. Therefore, it
would be noted that, the CBSL has only issued Rs. 24.6 billion as new
money to the economy throughout the year.

Relationship between NCG and Inflation
It is observed that some analysts have tried to point to a strong and linear
relationship between NCG and inflation. As such, efforts have been
made to find out the correlation between NCG and inflation. Those also
interpret the results to claim that CBSL’s money printing has caused
inflation in 2007.
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As explained above, it is not correct to use NCG as “money”. Hence, the
correlation between the level of NCG and CCPI inflation is spurious. The
relationship between inflation and monetary aggregates is not that
simple and usually it is observed with a considerable time lag. All
existing empirical evidence suggests that any change in monetary
aggregates influence inflation with a significant time lag. For some
countries it takes well over 24 months to have the full impact of changes
in monetary aggregates on inflation.
Chart 1: NCG Growth & CCPINpp
200.0
25.0
NCG Growth
CCPINpp
150.0
20.0
15.0
50.0
10.0
0.0
Oct-07
Oct-06
Jan-07
Apr-07
Jul-07
0.0
Jul-05
Oct-05
Jan-06
Apr-06
Jul-06
-100.0
Jul-04
Oct-04
Jan-05
Apr-05
5.0
Jan-04
Apr-04
-50.0
%
%
100.0
It is also not correct to compare a stock variable and a flow variable
together. NCG is a stock given as at a particular date and inflation is the
change in price level during two periods.
If there is a need to find out such a relationship, it would be more
realistic to compare the change in NCG as against the rate of inflation. It
is well observed that, the change in NCG and inflation measured by the
CCPI (N) - New Colombo Consumers’ Price Index (and even the old
index) show a weaker correlation. In fact, the correlation co-efficient is
only 0.26 per cent, which means there is no robust relationship between
the two variables.
If it is possible to demarcate a simple relationship between NCG and
inflation, the policy implication would also be very clear and obvious. If
the above relationship is valid, inflation can be brought down easily by
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maintaining NCG at a constant level for a few months. The Central Bank
would only need to maintain NCG at a certain level irrespective of other
monetary variables such as NFA, reserve money or broad money. But
maintaining inflation at low and stable levels is not that simple. The
prudent and responsible monetary policy of any Central Bank needs a
thorough analysis of inflation. Hence, it is imperative to examine several
other factors that affect inflation in order to conduct a proper scientific
analysis. This is the reason many central bankers and academicians
around the world have developed several sophisticated inflation models.

Factors affecting Inflation
The changes in money supply are a primary causal factor affecting price
stability. Hence, there is no argument about the harmful impact of
excessive monetary expansion. Definitely, excessive monetary expansion
is an evil as it creates high and persistent long-term inflation.
The classic explanation of demand pull inflation is that there is too much
money chasing too few goods. As more and more money is created, it is
owned by the people and businesses and they would proceed to spend it,
thereby making efforts to buy more goods than produced and more than
those available for purchase. If the money supply continues to increase
above the desirable levels, people would keep bidding each other for the
increasingly scarce goods and prices would keep increasing. In summary,
the answer to the question whether inflation is a monetary phenomenon,
in the long run, is yes. No serious inflation can take place without rapid
money growth.
But at the same time, in a modern economic system, perhaps money is
not the only culprit. The point is that in the case of cost –push inflation
(due to supply constraints or wage pressures) sometimes the money
supply may be the follower rather than the leader in the inflation process.
In the meantime, low productivity also has a huge impact on generating
inflationary pressures. The lower productivity allows cost increases that
flow through to product prices and thereby raises inflation. The lower
productivity growth thus represents a negative supply shock that
generates inflationary pressures.
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Hence, it is obvious that inflation is driven both by supply and demand
side factors. Long-term trend in inflation is due to demand pressures;
however, short-run fluctuations are due to supply side factors. It is vital
to consider these two aspects in order to depict a true picture of
movements in inflation in a country.
Recent Behaviour of Inflation in Sri Lanka
The recent movement in inflation in Sri Lanka is largely explained by
supply side factors. Sri Lanka’s inflation has been suppressed to a certain
extent in the past through subsidized fuel prices. Since those prices have
now been adjusted inline with international market prices, a one-off
increase in inflation appeared. In fact, inflation was on a downward
trend during the first half of 2007 benefiting from the lagged effect of
tight monetary policies pursued since 2004. It surged beyond
expectations and projections during the second half of the year largely
due to factors beyond the control of the Central Bank.
Chart 2: Domestic and Import Contribution to the
Change in CCPI (N)
100.0
80.0
60.0
%
40.0
20.0
Domestic contribution
J-08
D-07
N-07
O-07
S-07
A-07
J-07
J-07
M-07
A-07
M-07
F-07
0.0
J-07

Import contribution
CBSL announced its monetary policy framework in the Road Map:
Monetary and Financial Sector Policies for 2008 on 2 January 2008. CBSL
expects inflation to decelerate to around 10 – 11 per cent by end 2008 and
to a single digit by end 2009 with the phasing out of the one-off impact of
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reforms. This would be facilitated by the moderation of already
addressed demand driven pressures.
However, such inflation projections have been based on certain
assumptions such as international commodity prices remaining stable
during the year as predicted by experts. Any changes to such
assumptions may cause deviations in inflation from projected levels as in
2007. Therefore, although the Central Bank is confident about the
curtailing of demand pressures, in the meantime it needs to be cautious
about the price pressures that may arise through supply side shocks.
CBSL needs to vigilantly monitor each and every movement in the
economy and sense the pulses of policy measures. If any adverse
developments are perceived in the inflation front, particularly through
deviations in money, credit and fiscal variables, CBSL is required to
adopt timely and precautionary measures since “the price stability is not
everything, but without price stability everything is nothing!”
ANIL PERERA
Economist
Money and Banking Division
Economic Research Department
Central Bank of Sri Lanka
[email protected]
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