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.

All over the world, maintaining price stability has become the over-riding objective of Central Banks. In such context, maintaining 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.

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.

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. 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.

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.

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.

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 CBSLmoney printing has caused inflation in 2007.

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.

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 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.

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.

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.

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.

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 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!"