Inflation in srilanka

[INFLATION] February 3, 2014
A d v a n c e d D i p l o m a i n B u s i n e s s M a n a g e m e n t Page 1
Introduction
According to the modern central banking practices, maintaining economic and price stability has
become one of the core objectives of Central Bank of Sri Lanka as in many other developing
countries. The concern with maintaining price stability stems not only from the need to maintain
overall macroeconomic stability, but also from the fact that price stability forms a better
environment for investment, output, and employment etc. Over the decades, experience of many
countries suggests that price stability promotes economic growth. Therefore policy makers
believe, when inflation crosses a reasonable limit in the economy that can adversely affect other
macroeconomic variables and in turn undermines its steady level of the economy.
In recent years, experiences in both developed and developing countries have shown that rise in
the price of essential commodities; particularly food and oil items affected almost all the
countries in the world. Hence every country was under pressure to control the inflation level and
the Central Banks of these countries have taken various measures to maintain the price stability.
Sri Lanka‟s economy is not exceptional with respect to this issue since it heavily depends on
these two items. Following the economic liberalization, the expansionary economic policies
followed by the government and the Central Bank of Sri Lanka resulted in improvements in
various macroeconomic indicators including economic growth, which remained above five
percent. At the same time, continuous rise in the general price level in the economy has emerged
an important macroeconomic problem all over the country.
After finishing the module “Macroeconomic” I have been asked to fulfill a report on one of the
macroeconomic issues that I learnt at the university with regard to macroeconomic module as the
end semester assignment. So it‟s one of the best chances I‟ve got to study the inflation in
Srilanka as it gave me the practical knowledge as well as theoretical knowledge in best level.
So with that, I am pleased to present about inflation that I learnt at the university on behalf of the
Macroeconomic module. By studying this report you would be able to understand what is
inflation and it‟s situation in Srilanka.

Objectives
 To analyze the experience of inflation in Sri Lanka for the period 2008 to 2013.
 To study about inflation.
 To cover my assignment of writing an analytical report of inflation.
 To confirm my knowledge which I learnt by Macroeconomic module.
 To write a report in proper way according to its formal format.

Inflation
Inflation occurs when the general level of prices is rising. Today, we calculate inflation by using
price indexes-weighted averages of the prices of thousands of individual products. The consumer
price index (CPI) measures the cost of a market basket of consumer goods and services relative
to the cost of that bundle during a particular base year.
If inflation was always easily forecastable, then it is hard to imagine how (at least moderate)
inflations or deflations may pose a pressing economic problem (at least, relative to all the other
things we have to worry about). Nominal prices could in this case be contractually agreed upon
in a way that leaves the underlying „real‟ prices (including wages and interest rates) at their
„correct‟ levels.
Of course, inflation is not always easily forecastable. This appears to be especially true for
economies experiencing very high rates of inflation. It is a fact of life that most real-world
contracts are stated in nominal terms and that these terms depend, at least in part, on the forecast
of inflation. If inflation is highly variable, it is not easy for nominal contracts to ensure the
„proper‟ allocation of real resources. Unexpected inflation is viewed as being undesirable for two
reasons. First, if contracts are not indexed to inflation (normally, they are not) and if contracts
are costly to renegotiate (as is surely the case), then an unexpected inflation results in a
redistribution of resources (for example, from creditors to debtors). Second, if indexation and/or
renegotiation is costly, then inflation uncertainty is likely to entail resource costs and the
curtailment of economic activity.

Consequences of inflation
 Income redistribution: One risk of higher inflation is that it has a regressive effect on
lower-income families and older people in society. This happen when prices for food and
domestic utilities such as water and heating rises at a rapid rate.
 Falling real incomes: With millions of people facing a cut in their wages or at best a pay
freeze, rising inflation leads to a fall in real incomes.
 Negative real interest rates: If interest rates on savings accounts are lower than
inflation, people who rely on interest from their savings will be poorer. Real interest rates
for millions of savers have been negative for at least four years.
 Cost of borrowing: High inflation may also lead to higher interest rates for businesses
and people needing loans and mortgages as financial markets protect themselves against
rising prices and increase the cost of borrowing on short and longer-term debt. There is
also pressure on the government to increase the value of the state pension and
unemployment benefits and other welfare payments as the cost of living climbs higher.
 Risks of wage inflation: High inflation can lead to an increase in pay claims as people
look to protect their real incomes. This can lead to a rise in unit labour costs and lower
profits for businesses
 Business competitiveness: If one country has a much higher rate of inflation than others
for a considerable period of time, this will make its exports less price competitive in
world markets. Eventually this may show through in reduced export orders, lower profits
and fewer jobs, and also in a worsening of a country‟s trade balance. A fall in exports can
trigger negative multiplier and accelerator effects on national income and employment.
 Business uncertainty: High and volatile inflation is not good for business confidence
partly because they cannot be sure of what their costs and prices are likely to be. This
uncertainty might lead to a lower level of capital investment spending.

One benefit of inflation
According to James Tobin, a little amount of inflation is good for economy. Geroge A. Akerlof,
William T. Dickens and George L. Perry also believe that little inflation say, 2 or 3 percent per
year is a good thing.
The justification is as follows:
Nominal wage cuts are rare. That is, a 2-percent wage cut in a zero inflation situation is equal to,
in real terms, 3-percent rise in nominal wage with 5-percent rise in inflation. But worker strongly
dislike nominal wage cut.
So, the idea is not to cut nominal wages. With small positive inflation, some real wages will go
up (where nominal wages are raised) and some others will go down (where nominal wages are
either not changed or increased in a lesser proportion). It will help to achieve economic
efficiency and lower rate of unemployment. For this reason, some economists argue that little
inflation rate lubricates the economy or “greases the wheels” of labor market.
Types of inflation
The modern economic theory describes three types of inflation:
(1) Cost-push inflation
Cost-push inflation is due to wage increases that cause businesses to raise prices
to cover higher labor costs, which leads to demand for still higher wages (the wage-price
spiral)
(2) Demand-pull inflation
Demand-pull inflation results from increasing consumer demand financed by
easier availability of credit.
(3) Monetary inflation
Monetary inflation caused by the expansion in money supply (due to printing of
more money by a government to cover its deficits).

Inflation Measures in Sri Lanka
Inflation is measured using a number of indices such as Colombo Consumers‟ Price Index
(CCPI), Colombo District Consumer Price Index (CDCPI), Greater Colombo Price Index
(GCPI), Wholesale Price Index (WPI) and Sri Lanka Consumer Price Index (SLCPI). The CCPI
is the official measure of price changes with food items representing 62 per cent, clothing 9 per
cent, fuel and light 4 percent; rent 6 per cent, miscellaneous 19 per cent in total weights. Food is
an important item in all of the indices representing relatively larger portion in all of the above
mentioned baskets.
Inflation rates in Sri Lanka
Ye
ar
Jan Feb Mar Apr Ma Jun Jul Aug Sept Oct Nov De
c
Annua
l
Averag
Rate
20
13
9.80
%
9.80
%
7.50
%
6.40
%
7.28
%
6.84
%
6.06
%
6.34
%
6.22
%
6.73
%
5.62
%
4.69
%
6.94
%
20
12
3.75
%
2.71
%
5.44
%
6.11
%
7.00
%
9.26
%
9.89
%
9.52
%
9.10
%
8.91
%
9.50
%
9.20
%
7.53
%
20
11
6.27
%
7.23
%
7.73
%
8.82
%
8.14
%
7.08
%
7.44
%
7.00
%
6.38
%
5.14
%
4.74
%
4.89
%
6.74
%
20
10
7.09
%
7.55
%
7.13
%
6.79
%
5.66
%
5.14
%
4.44
%
4.97
%
5.71
%
6.50
%
6.90
%
6.82
%
6.22
%
20
09
10.45
%
7.45
%
5.24
%
2.61
%
3.59
%
0.75
%
1.20
%
0.97
%
0.97
%
1.58
%
2.95
%
5.03
%
3.56
%
20
08
20.88
%
21.62
%
23.67
%
24.92
%
25.80
%
28.31
%
26.63
%
24.83
%
23.90
%
19.86
%
16.03
%
13.8
8%
22.53
%

20.88
21.62
23.67
24.92
25.8
28.31
26.63
24.83
23.9
19.86
16.03
13.88
10.45
7.45
5.24
2.61
3.59
0.75
1.2 0.97
0.97
1.58
2.95
5.3
7.09
7.55
7.13
6.79
5.66
5.14
4.44
4.79
5.71
6.5
6.9
6.82
6.27
7.23
7.73
8.82
8.14
7.08 7.44
7 6.38
5.14
4.74
4.89
3.75
2.71
5.44
6.11
7
9.26
9.89
9.52 9.1
8.91
9.5
9.29.8
9.8
7.5
6.4
7.28
6.84
6.06
6.34 6.22
6.73
5.62
4.69
0
5
10
15
20
25
30
Jan Feb Mar Apr May Jun Jul Aug Sept Oct Nov Dec
Sri Lankan Inflation Rates
2008
2009
2010
2011
2012
2013

22.53
3.56
6.22
6.74
7.53 6.94
0
5
10
15
20
25
2007 2008 2009 2010 2011 2012 2013 2014
Annual Average Inflation
Annual Average
Inflation
Above figure shows the trends of inflation in Sri Lanka during the past six years period,
expressed as the annual percentage change in the Colombo Consumer Price Index (CCPI).
According to the above figure, following the economic analysis, inflation rate in Sri Lanka has
been volatile. As measured by the Colombo Consumer Price Index (CCPI), in 2008 the inflation
rate recorded was at a peak of 22.6 percent. But in 2009 it decreased up to 3.56 percent. Since
2009, the rate increased gradually until 2012. However, in 2013, the inflation rate decreased to
6.94 percent.
The rapid increase in money supply due to heavy government reliance on the Central Bank for
deficit financing, huge government expenditure on war and other infrastructure projects, import
price increases, coupled with the continuing depreciation of the Sri Lankan Rupee caused
significant inflation.
The main means of money supply is the printing of notes and coins and the creation of money by
the banking system of the country. However, the Central Bank is in a position to exercise direct
as well as the indirect means for the conduct of the monetary policy in mopping up the excess
liquidity in the market and thereby controlling inflation.

In the year 2008
The rapid rise in world commodity prices during 2008, most notably fuel and food prices
coincided with a sharp increase in inflation in Sri Lanka during the first half of the year. The
lagged effect of adverse monetary conditions that prevailed in the past as well as adverse
developments in commodity prices contributed to the increase in the index values in the first half
of 2008. The increase in consumer price index during the first half of the year was also fuelled
by the low supply of domestically produced agricultural commodities and the very high prices of
imports, particularly food items, crude oil and petroleum products, in the international market.
The upward revisions of the fuel prices, in late May 2008, had a significant impact on the surge
in the level of CCPI.
In the year 2009
The effect of stringent monetary policy adopted by the CBSL during the previous two years and
the decline in commodity prices in the international market coupled with improved domestic
supply conditions and the downward revision of administered prices, aided the rapid deceleration
in inflation. Inflationary pressure exerted through increase in wages of public and private sector
employees was contained through favorable developments in supply side factors, enhanced labor
productivity as well as the prudent monetary policy pursued by the CBSL.
In the year 2010
The relatively low and stable level of inflation during the year was mainly attributable to the
improved domestic supply conditions and supportive fiscal policies aided by the adjustment in
import duties, and downward revisions in administered prices as well as the prudent monetary
policy stance. In addition, the relatively stable exchange rate and improved productivity also
helped lower price pressures during the year. Meanwhile, the core inflation, which is derived by
excluding food and energy items from the CCPI basket, followed a decelerating path both in
terms of annual average and year on-year bases in 2010.

In the year 2011
The relatively high inflation observed during the first few months of the year was mainly due to
an upsurge in prices as a result of supply disruption caused by adverse weather conditions that
prevailed in major cultivation areas. Although the price escalation due to supply disruptions was
temporary, the increase in inflation on a year-on-year basis remained for a few months owing to
the low base in 2010. Further, several upward revisions of administered prices, especially of LP
Gas and petroleum products during the year also impacted directly and indirectly on inflation, at
varying intensities. The real wage increases during the year also exerted some pressure on prices
from the demand side. However, significant improvements in the domestic supply conditions
coupled with the moderation of prices of food commodities in the international market, amidst a
relatively stable exchange rate helped contain inflation in 2011. Benign inflation expectations
also helped restrain any undue pressure on the general price level.
In the year 2012
The relatively lower inflation observed during the first few months of the year was due to the
improved domestic supply of food items and a moderation in international prices of imported
commodities. The rising trend in inflation from the second quarter 2012 was due to a number of
factors, such as the upward revisions of administered prices of petroleum products, LP gas,
electricity and bus fares; the depreciation of the rupee; the increase in duties on several imported
commodities; and the increase in food prices due to crop damage caused by both drought and
floods. Although food price escalations due to supply disruptions were temporary, the low base
that prevailed in 2011 also contributed to inflation remaining at higher levels. The real wage
increases would have exerted some cost and demand pressures on inflation. However, improved
supply conditions of agricultural production, downward revisions of some administered prices
and duties on imported items and demand management strategies together with managed
inflation expectations helped contain inflation at single digit levels throughout the year.

In the year 2013
The contribution to the decline in annual average inflation to 6.9 per cent in 2013 came mainly
from slowdown in the price increase in the Non-food category, which grew only by 6.1 per cent
in 2013 against that of 10.0 per cent in 2012. The impact of the upward price revision of petrol,
diesel, kerosene and bus fares on inflation was lower in 2013 than in 2012. As a result, the
average price in the Transport sub-category increased only by 4.6 percent. In addition,
comparatively lower increase in the average prices in the sub-categories of Health, Furnishing,
Household equipment and routine household maintenance and Clothing and footwear in 2013
than in2012 contributed favorably to this decline. However, relatively high increase in the Food
and non-alcoholic beverages category by 7.9 per cent in 2013 compared to 2012 had an upward
pressure on inflation.

Recommendations
1. Government should set effective target for a low but positive rate of inflation.
The first step is for the CBSL to try and predict future inflation. They should look at various
economic statistics and try to decide whether the economy is overheating. If inflation is forecast
to increase above the target, the CBSL should increase interest rates.
Increased interest rates will help reduce the growth of Aggregate Demand in the economy. The
slower growth will then lead to lower inflation. Higher interest rates reduce consumer spending
because:
 Increased interest rates increase the cost of borrowing, discouraging consumers from
borrowing and spending.
 Increased interest rates make it more attractive to save money
 Increased interest rates reduce the disposable income of those with mortgages.
 Higher interest rates increased the value of the exchange rate leading to lower exports and
more imports.
2. As wage growth is a key factor in determining inflation, if wages increase quickly it will
cause high inflation. So government should try to limit wage growth.
3. Increase the local productivity and export local products to international market and gain
foreign currency to local market.
4. Improve the performance of aggregate supply in local market.
5. Decrease the interest rate of financial loans and borrowings.
6. Increased consumer interest rates to discourage borrowing and spending, increased
borrowing costs.
7. Increased rate mortgage to reduce people's disposable income.

Conclusion
The purpose of this study was to analyze the experience of inflation in Sri Lanka for the period
2008 to 2010.Identified that Inflation is simply the percentage change of CCPI (Colombo
Consumers‟ Price Index) which is the official price index in the country. Identified that high and
volatile inflation can damage both individual businesses as well as consumers and hence, to the
economy as a whole. Persistent inflation in goods and services can result in high social costs,
too. Thus the intension was changed in to forecasting of price levels in Sri Lanka. Monetary
policy practitioners are of the view that inflation is detrimental to economic growth while I
believe that moderate inflation can contribute to economic growth. The results of this study
emphasize the need to put in place a stable macroeconomic policy in an effort to maintain price
stability, since low inflation would enhance economic growth in Sri Lanka.

References
Books
 Paul A.Samuelson & William D.Nordhaus, ECONOMICS, 18th
edn. Tata McGraw Hill,
New Delhi.
 (David Andolfatto 2005, Macroeconomic Theory & Policy, p.184)
 I.Dayarathna, Macro-economic for advance level and other professional exams. Chapter
18,p.354
 Deepashree & vanita Agarwal, Macroeconomics, Unit 3
 Annual reports 2008-2013, Central Bank of Sri Lanka.
 Arida, A and Francisco, J.V. (2005). Does Political Instability led to Higher Inflation: A
panel Data Analysis, IMF Working Paper Series: WP 0549.
 Cooray, A.V. (2008). ―A Model of Inflation for Sri Lanka‖ Review of Applied
Economics, 4 (1-2).Karunathilaka,H.N.S. (1974). ―Inflation and the Sri Lankan
Economy‖, Staff Studies, Vol.4.No.2, Central Bank of Sri Lanka, Colombo, p. 185-197
Web addresses
 http://www.statistics.gov.lk/page.asp?page=Inflation%20and%20Prices, charts and tables
 http://books.google.lk/books?id=W0KW7y3ylEC&lpg=PP1&dq=macroeconomics&pg=
PP1#v=onepage&q=macroeconomics&f=false
 http://tutor2u.net/economics/content/topics/inflation
 http://www.investopedia.com/terms/i/inflation.asp
 http://www.tradingeconomics.com/sri-lanka/inflation-cpi
 http://en.wikipedia.org/wiki/Inflation
 http://economictimes.indiatimes.com/definition/wholesale-price-index
 https://www.google.lk/search?q=INFLATION&biw=1366&bih=629&tbm=isch&tbo=u&
source=univ&sa=X&ei=Zf7tUv2QCMfOiAfUrYDQBw&ved=0CE0QsAQ#imgdii=_
 http://inflationdata.com/articles/2012/07/14/effects-of-inflation/
 http://mises.org/money/3s2.asp
 Professor Dani athapaththu,2009, Macro-economic for advance level,p294 pdf

Inflation in srilanka

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