ISSN: 1391 - 0531
Sunday, July 08, 2007
Vol. 42 - No 06
Financial Times  

A child’s guide to taming inflation

By W.A. Wijewardene
Deputy Governor, Central Bank of Sri Lanka

Anoma was puzzled. Her teacher who had read the latest Central Bank Press Release made the announcement in the class that the Bank’s tight monetary policy action had yielded the favourable result of lowering inflation from 20 % per annum to 15 % per annum.

She also had read the newspaper headline “Inflation Substantially Tamed Down”. But when she came home from school, her mother was making the usual accusation after she had made her weekly trip to the market.

“All prices have been up from the previous month. I don’t know how we could live,” her mother had been telling everyone who had gathered in the kitchen. Anoma felt that all her family members had been highly worried.

She too was worried. Was her teacher wrong? Had she picked up some wrong announcement of the Central Bank? Who was correct and who was wrong? She had no patience until she could find it out.

Fortunately for her, that evening, their house was visited by Fernando Uncle who worked in a bank. He was a well read person and knowledgeable on those issues. Anoma, as she had done on many occasions in the past, placed her puzzle before him. It led to a long session of questions and answers that went on till very late that evening.
The following is a transcript of the discussion that took place:

Anoma: Fernando Uncle. Is it true that inflation is falling?

Fernando Uncle: Yes, my dear. Inflation is falling.
But why do you ask me this question?

A: But my mummy says that prices of all goods have gone up. How come that prices have gone up if inflation has been falling?

Uncle: (smiling) My dear, it can happen. That’s because ‘prices going up’ and ‘inflation coming down’ are two different things. We shouldn’t confuse those two events.

A: (with a puzzled look) Fernando Uncle, are you kidding? Can you explain that to me?

Uncle: I’ve to explain to you how inflation is measured and what we mean by inflation. Then you can understand it better.

A: Yes, Uncle. But, wait until I get a note book to write it down.

(At this stage, both Anoma’s father and mother, too, came to the sitting room and start to listen to the conversation. They too participate in the discussion on and off.)

Uncle: What we mean by inflation is a very simple thing. We take a typical consumer and find out what types of goods and other services he normally consumes to keep him generally going.
When the prices of all those goods and services generally move up over a considerable period of time, we call it inflation. It can be done by comparing the total budget he has to spend to buy that basket between two time periods. For simplicity’s sake, let us suppose that he uses only two goods; rice and coconuts. Five kilos of rice and 10 coconuts.
If a kilo of rice is 10 rupees, he spends 50 rupees on rice. If a coconut is five rupees, he spends further 50 rupees on coconuts. His total budget is therefore 100 rupees. This is the starting point.
Now suppose that after one year, the price of rice goes up to 15 rupees a kilo and the price of coconut to 10 rupees a nut, he then spends 75 rupees on rice and 100 rupees on coconuts. His total budget has thus gone up from the earlier 100 rupees to 175 rupees. We can say that his cost of living has gone up by 75 rupees or, in this case, by 75 %.

A: (yawning) Pretty boring.
But, is this 75 percent equal
to the rate of inflation?

Uncle: No. ‘Cost of living’ and ‘inflation’ are two different things. If the cost of living rises over a number of years, then, we call it inflation. If it happens only one time, then, it’s just an increase in cost of living.

A: Do they calculate the inflation by comparing two budgets?

Uncle: No. It’s a much more complex procedure than that. For that, they compute what is known as a consumer price index. It’s basically calculated on the same basis. But, when they do that, they select a base year and express the value of the budget in that year as equivalent to 100 units. Any increase from that index over a period of time, when expressed as a percentage, is called inflation rate.

A: I can remember now. Our teacher taught us that, in Sri Lanka, we calculate an index called the Colombo Consumers’ Price Index for calculating inflation.

Uncle: Yes, my dear. You’re correct. This index is the official price index in Sri Lanka for wage adjustment purposes. It’s known by laymen as simply CCPI and has a base year as far back as 1952.

Anoma’s Father: (exclaiming) 1952? Why haven’t they changed it all these years?

Anoma: (intervening) Oh, Dad, our teacher says that there were a lot of opposition to changing that. Especially from the unions.

Uncle: Yes. Unions think that if they change it, they would be disadvantaged when the wages are adjusted, because the new index has a lower index value. But, that’s totally a groundless fear. That’s because when you use a new index, it would have a higher level of compensation whenever the index increases. So, workers don’t get disadvantaged.

Anoma’s Father: I’m interested in that. Can you clarify it further?

Uncle: For instance, in the CCPI, the budget value of a unit is just Rs 2.02. But, if we use an index like the Sri Lanka Consumer Price Index that has been introduced by the Department of Census and Statistics recently, the budget value of a unit is Rs 47.86. You’ll see that a unit increase in the new index is equivalent to about a 24 unit increase in the old CCPI! So, the fear of the unions is totally baseless. Whatever the index you use, you get the same compensation value in terms of the amount of rupees you would get.

A: Our teacher said that it is the Central Bank that tames inflation in Sri Lanka. How do they do that? By controlling the CCPI?

Uncle: ( laughting) No. Controlling CCPI is just a technical exercise. It won’t rid a country of inflation. For that, the Central Bank controls the total demand called the aggregate demand by controlling the source of that demand. That’s the total amount of money in the hands of the public who would use that money to buy goods and services in excess of the available supply. By doing that, the Central Bank keeps a check on inflation. In other words, as you say, tame the inflation.
Anoma’s Mother: I think the Central Bank is cheating all of us. If they have tamed inflation, how can I find that prices have gone up, every time I go to the market?

Anoma’s Father: Yes. That was also puzzling to me. I think that the people in the Central Bank are all cheating us.

Uncle: No, my friends. Both of you have confused the event of rising prices with declining inflation. The Central Bank never says that prices have declined. What it says is that the rate at which prices are rising is declining. In other words, prices are still rising at a falling rate.
Anoma’s Parents in unison: Mr. Fernando. It’s you who confuse all of us. You say that prices are rising. At the same time, you contradict yourself by saying inflation is falling. How can that both can be correct at the same time?

Uncle: Let me explain this a little further. Then, it would be easy for you to understand.
Imagine Susanthika running the 100 metre sprint in 11 seconds. She is running it at that fast speed. Everyone who sees her will tell us that she is running very fast. Now suppose that she gets some leg injury and cannot run so fast and slows a little. Now she takes double that time to finish the sprint so that she finishes it in 22 seconds. People would see her running slower than before. Her coach will say that the speed at which she runs the 100 meter sprint has now declined. What does it mean, Anoma? (He turns to Anoma and asks her.)

A: It means that Susanthika is still running but at a slower speed. She isn’t stationary or hasn’t stopped running. She will reach the final point not so quickly as she had been running earlier. But, still she would be reaching there a little later.

Uncle: Exactly. Susanthika is still running. When the Central Bank says that the inflation rate has declined, that is exactly what the Bank has meant. Prices are still rising, but at a slower rate. So, the people at the Bank have not cheated you. Instead, you guys simply have misunderstood it.

Anoma’s Father: Oh, come on Fernando. You have to do better than that. Explain to us with an example.

Uncle: OK, ok. If you say so. Suppose in January last year, the price index was at 100 and in January, this year, it’s 120. It means that prices have increased by 20 % during the year ended in January this year.
Now suppose that in April last year, the index was at 110.
In April this year, it records a level of 126.5. Compared with January this year, prices have risen by 6.5 units or 5.4 %. But the rate of increase over the year ended in April this year has declined what it was at 20 % in January to 15 % in April. In other words, the Central Bank has tamed the inflation a little.

Anoma’s Mother: Mr. Fernando, that’s not a big deal. The Bank has allowed the prices to increase, but gets some sort of a perverse satisfaction by saying that it has attained a great victory. What we want is not that prices have risen at a slower rate. We want, in fact, prices to fall, so that we have a bigger deal for our budget.

Uncle: You’ve every reason to have that expectation as a housewife. That’s because when the prices fall, you spend a lesser amount to buy the same quantity and you have made a good deal. But, in a growing dynamic economy, that is too much of a goal to attain. It’s also not desirable for a country to experience falling prices.

A: Why is it, Uncle?
Uncle: When a country has inflation at a moderately high level as 20 %, it’s dangerous to bring it down to zero level all of a sudden. It’s like a patient who has been hit by some bacterium and physicians trying to neutralize that bacterium gradually rather than abruptly. They can administer him with an over-dose of antibiotic to have a faster eradication of bacteria, but it would damage his vital organs and kill him. The Central Bank also has to function like a physician. It has to rid the country of inflation. But, it certainly cannot kill the economy in the process. So, it does a gradual fight with inflation. First, it brings it down to, say 10 %, then to 5 % and so on. In other words, it should be a gradual process.

A: But, why is it not desirable for prices to fall in an economy?

Uncle: It’s quite simple, Anoma my dear. When prices fall and if there is a corresponding reduction in the costs, then, of course, fallen prices would not harm the producers. If it doesn’t happen, fallen prices mean that they are getting a lower profit. If the prices further fall so that their profits are now converted to losses, then they become bankrupt.
They would fire workers and there would be a mass unemployment and economic recession. So, the joy of the fallen prices for consumers would be a very short-lived one because in the next round, they wouldn’t have goods to consume at all. Therefore, the best thing is to stabilize prices and not allow them to fall.

Anoma’s Mother: I’m disappointed. What you mean is that consumer prices should not fall at all?

Uncle: Exactly. What should be planned is to raise income in real terms and not reducing prices below their cost of production.
Besides, in a growing economy, prices also rise at one to two percent, because of the quality improvements and consumers are willing to pay a higher price for the improved quality. At the same time, prices might fall due to improvements in productivity and technological advancements. These two forces work against each other and moderate price increases, if the central banks adopt appropriate monetary policies to prevent them from escalating further. So, the Central Bank’s job is to bring it to a low level which one can call as the socially desirable level. So, you people should have patience and trust the Central Bank.

Anoma, Anoma’s Father and Anoma’s Mother in unison: Thanks for providing us some valuable lessons.



Top to the page

Copyright 2007 Wijeya Newspapers Ltd.Colombo. Sri Lanka.