Business Times

Monetary and fiscal policies are like ‘twin brothers’

On devaluation

The recent devaluation of the rupee has drawn bouquets and brickbats and triggered a media debate on the role of the Treasury (through which the 3 % devaluation was announced in the budget) and the Central Bank.

Asked for the role of the Central Bank in this area of policy, Prof Sirimal Abeyratne, a senior economist attached to the University of Colombo had this to say: “First let me clarify the definition problem attached to this issue and, then move on to the question of the responsibility of the Central Bank Governor. Devaluation per se does not either raise inflation or reduce inflation, because inflation means ‘a constant increase in average price level’.

As the way it is defined, one-time or short-term increase in price level does not mean inflation. Therefore, devaluation will obviously raise the domestic price of imports, but it is not inflation because it is one-time price hike. If you import US$1 worth commodity you have to pay Rs 110 before the devaluation and $114 after the devaluation. Therefore, devaluation also leads to an increase in the total import bill, although the Budget Speech itself wrongly refers to a ‘reduction’ of the import cost! The only way to have a lower import expenditure is through a greater cut down in import demand.

Instead of the Governor of the Central Bank I would use the term ‘monetary policy’ and, instead of the Secretary to the Finance Ministry, I would use the term ‘fiscal policy’. Apparently, the primary objective of the Central Bank is to maintain ‘price stability’ and, for that matter ‘system stability’ too so that it is the responsibility of the Central Bank to use the monetary policy to keep inflation under control. The Central Bank can be in trouble not necessarily due to its own fault, because of the fiscal policy which is the ‘twin-brother’ of monetary policy.

Let me give you an example: Police charged, as usually is the case, a motorist who met with an accident ‘for failing to prevent the accident’. But that motorist who met with an accident must have been put into that trouble by another motorist who drove recklessly. But the Police which failed to identify the actual culprit, as usually is the case, charged the victim and, not the real accused who was let off, free.

The Central Bank lends to the government excessively, not because the Central Bank’s likes to do so, but because the Treasury asks for that. Apparently, in many countries the Central Bank also has the autonomy to say ‘no’ to the government, when borrowings from the Central Banks exceed reach limits. However, why does the Treasury ask for it? Because government spending is too much. Therefore, both monetary and fiscal policies are like ‘twin-brothers’ who have to share the good and evil equally.”

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