Issue 1: Rethinking Inflation Policy in Sri Lanka : When Prices Rise Faster Than Incomes
Sri Lanka’s 5% inflation target distorts investment, arbitrarily redistributes wealth, and threatens external stability. The central bank should replace it with a 2% ceiling argues Ravi Ratnasabapathy
by Ravi Ratnasabapathy
1. Introduction
Money is only important for what it will procure. One of the effects of over-issue of the money stock (or inflation), is the fall in its value. This is reflected in the rising prices of goods and services. When incomes don’t keep up with rising prices, living standards fall and poverty increases. Inflation also affects different people in different ways based on the nature of their employment and spending patterns.
It may take many years for incomes to catch up with rising prices, particularly housing which can become unaffordable. If inflation keeps rising, there may never be a full catch-up, creating permanent gaps in the economic well-being of people. Older people whose savings are decimated may never be able to recover their living standards.
Our recent experience shows the kind of avoidable suffering that is caused by inflation, especially in periods of rapid monetary depreciation. While there is universal consensus that high inflation is destructive there is also a belief among some that at low levels it may be beneficial to business owners and producers who will increase output.
However, any temporary demand that businesses experience arises from an illusion: people mistake nominal incomes for real incomes and are initially induced to spend.
“In the face of record food price inflation, skyrocketing fuel costs and widespread commodity shortages, some 6.26 million Sri Lankans, or three in 10 households, are unsure of where their next meal is coming from, according to the latest food insecurity assessment from the World Food Programme (WFP), released on Wednesday.”(UN News, June 2022)
“Cost of living means at what rate the price levels are going up... inflation 5% mean cost of living will have to go up [right now 2%]. That is a sustainable increase...
..Only way for people [to manage]: by increasing their income, increasing their economic activities... GDP growth. GDP growing at 5% means economic value... growing by 5% every year which means COL going up 5% means if the incomes are going up by 5% that would compensate.” (CBSL January 2026)
The quote above states that if inflation is low, its impacts on households can be offset through a corresponding increase in income driven by economic growth. This is a standard proposition in orthodox macroeconomics: that money is neutral in the long run ie does not permanently alter real economic variables. Therefore “moderate” inflation is generally viewed as not inherently harmful, provided nominal incomes adjust in line with rising prices.
Does this hold true in practice?
The central claim of this essay is that because money enters the economy unevenly and alters relative prices and credit conditions, inflation cannot be relied upon to preserve real incomes or maintain macroeconomic stability, even at low levels.
The essay examines the conditions underlying the assumption of neutrality and argues that the conditions necessary for the neutrality of money in the long term do not hold in practice. The costs that arise if the neutrality assumption is lifted are heavy: the redistribution of wealth and distortions to the production structure and investment. In addition, credit growth that arises from a policy of creating positive inflation leads to disruptive fluctuations in real output that manifest in small open economies with reserve-collecting central banks as balance-of-payments crises.
Once the costs of inflation are considered, the case for a positive inflation target is weak. Policy should instead prioritise monetary and external stability through a low inflation ceiling.
The essay also questions whether the current inflation target is consistent with the CBSL’s statutory objectives. The CBSL’s mandate is to maintain domestic price stability and financial system stability. However, the inflation target has been set based on staff study that noted that GDP growth has an increasing relationship with inflation when inflation is around 4-7 per cent, in effect, interpreting the new monetary law as having a growth mandate.
Macroeconomic stability is the foundation of sustainable economic growth. It may be defined as stability in prices, the foreign exchange rate and the balance of payments. Repeated balance of payments crises have derailed Sri Lanka’s growth in the past, so avoiding these is necessary for sustained growth. According to the IMF’s standard Polak model, control over net domestic credit expansion is the key to stabilising the level of foreign currency reserves and therefore the balance of payments.
Thus attempts to stimulate output through monetary and credit expansion will contribute to external imbalances and balance-of-payments crises that ultimately undermine long-term growth and stability.
2. The orthodox case for positive inflation and its assumptions
The orthodox argument for inflation rests primarily on the claim that it helps avoid unemployment and deflation, both of which are viewed as economically and socially costly. Inflation is a “lubricant” that reduces frictions in a complex economy.
Overcoming “sticky” wages
Theoretically, if a firm or industry’s sales fall it could simply lower its prices and wages to stay viable. In practice, workers will resist nominal wage cuts. Legal contracts and morale effects also dissuade firms from trying to impose cuts. If costs do not adjust, the firm could go out of business, resulting in unemployment.
Inflation provides a “silent” solution to the problem. As inflation raises general prices while nominal wages are unchanged (or rise more slowly than prices) the real wage falls. Workers receive the same pay in nominal terms, but its purchasing power declines. This benefits the business because selling prices rise while labour costs remain fixed (or rise more slowly). Further, the injection of new money increases demand (or helps stabilise falling demand) for the products/services of firm/industry, even during downturns.
Avoiding deflationary spirals
Falling prices are often attributed to a contraction in aggregate demand, triggered by events such as a financial crisis. From the Austrian perspective, however, such crises are frequently preceded by periods of artificially low interest rates and credit expansion which generate unsustainable patterns of production and spending. When these imbalances unwind, spending falls, firms cut production and employment and incomes decline. This can set off a downward spiral in which lower incomes further depress spending. To arrest this, the central bank intervenes by creating new money. As the new money is spent, it supports aggregate demand and slows the contraction..
Closely related is the debt-deflation argument. When prices fall, incomes fall, forcing households and firms to cut spending in order to service their debt obligations. This can reinforce the downturn. Inflation is argued to counter these dynamics by supporting nominal incomes and spending: creditors are repaid, but in money with lower purchasing power.
Facilitating relative price shifts.
An economy is not static; some industries grow while others shrink. For resources to move to where they are needed some prices must fall while others rise. It is believed that many prices and wages are slow to decline in nominal terms. When general prices are rising, a sector can become cheaper relative to others simply by raising prices more slowly, avoiding explicit cuts that firms and workers resist.
This is the standard case for a low but positive inflation target. To be clear, the claim is not that inflation creates real wealth, but that it allows necessary economic adjustments to take place, supposedly with fewer disruptions, avoiding prolonged unemployment, debt distress and deflationary spirals.
This case depends on several assumptions about how money, prices, wages and credit behave in the economy. The validity of the policy depends on whether these assumptions hold true in practice.
2.1. The workings of inflation
Inflation works through the “money illusion”. People assume the value of money is stable so rely on its face or nominal value when making decisions. Inflation reduces the real value of money, but people don’t realise this so they respond to changes in nominal incomes and prices as if they were real. In this way, inflation can systematically distort perceptions and influence behaviour, even when underlying economic conditions have not improved.
The Labour Illusion: workers view their pay based on the number printed on their payslip. An unchanged or slowly rising wage may be acceptable, even if rising prices erode its purchasing power. In real terms, wages have fallen but the workers fail to realise this.
Borrowers Illusion: Similarly, borrowers may likewise continue to spend and service debt if their nominal income remains stable, even as their real income and standard of living declines.
Relative Price Adjustments: A similar process facilitates shifts in the broader economy. Instead of a struggling industry facing a painful, visible price collapses, its prices or wages simply rise more slowly than general inflation. This allows a sector to become “cheaper” in relative terms, shifting resources without visible cuts.
(For a further discussion on the money illusion refer Appendix 3)
2.3. The assumption of neutrality
In essence, the beneficial effects of inflation arise through sleight-of-hand; by manipulating perceptions to influence economic activity. Its proponents argue that this simply allows adjustments that would have to take place anyway to happen with minimal friction. If this view is correct then it is relatively harmless but for this to be true then changes in the money supply should not permanently alter real economic outcomes.
Known as the “neutrality of money” it suggests that while monetary expansion may shift relative prices and production decisions in the short run, these effects eventually dissipate, leaving behind nothing but higher nominal prices and incomes.
In the long run, inflation will lead to higher prices but the theory suggests that as incomes would have also risen, people are no worse off; unemployment is alleviated, the depression avoided and the economy returns to a steady state.
3. Why neutrality fails - conditions underlying the assumption
In order for the changes in money supply to leave impact only nominal variables without disturbing real economic relationships several stringent conditions would need to hold simultaneously. Sieroń(2019) identifies a total of nine conditions, four of the most important are discussed below. If these are not met, inflation will introduce distortions and inefficiencies to the economy.
Broadly proportional price adjustment
In the long run, all prices, wages and contracts would need to adjust in a broadly proportionate manner, so that relative prices and therefore resource allocation, remain unaffected, post transition.
An unchanged expenditure structure and idle capacity.
Recipients of newly created money would need to allocate it in the same proportions as before; across consumption and investment and specific goods and services. If spending patterns change, the structure of demand and therefore resource allocation changes.
In practice, when nominal incomes increase it is unlikely that patterns of spending will remain unchanged. The balance between spending and savings may also change.
Moreover, for monetary expansion to increase output without distorting the existing structure of production, idle capacity would need to exist in appropriate proportions across all sectors and stages of production. If new spending activates unused resources without diverting inputs from ongoing production processes, real distortions may be limited. However, such proportional slack across the economy is unlikely in practice.
Intertemporal Price Signals and Interest rates
Monetary policy operates partly through its influence on interest rates. For monetary expansion to be neutral with respect to real allocation, changes in interest rates would need to avoid materially altering intertemporal price signals (ie not alter savings or investment decisions).
If monetary policy pushes interest rates away from levels consistent with underlying time preferences and savings, the size and composition of investment may change, altering the structure of production.
Uniform distribution of new money
For the expenditure patterns to remain stable and the price adjustments to be broadly proportional, newly created money would eventually need to affect the cash balances of economic agents in a largely uniform manner.
In effect, once the adjustment process is complete, all individuals and firms would need to hold cash balances that are proportionately similar in real terms to those they held before the monetary expansion. If some groups receive and spend the new money earlier than others, relative incomes, prices and patterns of demand will change during the adjustment process, altering resource allocation and creating distributional effects.
These conditions are very difficult to satisfy in practice, primarily due to the fact that new money does not enter the economy uniformly. Instead, it is introduced at specific points, at specific times and through particular channels.
Even if economic agents fully anticipate inflation, monetary expansion will distort production decisions because newly created money enters through particular sectors and credit markets. Because new money does not enter proportionately across the economy, changes in demand, prices and investment patterns take place sequentially rather than uniformly.
4. The Cantillon effect
Richard Cantillon, writing circa 1730 observed that an increase in money supply does not affect all prices simultaneously or proportionately. Its economic consequences depend critically on where the new money enters the system.
“new money enters an economy at a specific point and... it takes time for the new money to permeate the economy. Since new money does not reach everyone at the same time, the injection of money increases the purchasing power of those who receive the new money first, enabling them to bid resources away from those who receive that money at a later time. As a result, relative prices will change, resources will be reallocated and income will be redistributed during the time interval between money injection and its final permeation in the economy.”[emphasis added] (Chen and Angus, 2012)
Modern central banks create new money through the banking system. Access to the new money depends on the ability and willingness to borrow. Governments, banks and large businesses are usually the early recipients. Their spending will determine the sectors which benefit from new spending. The demand for resources and changes to prices will follow the flow of money, sequentially and unevenly. Thus economic activity in particular sectors are stimulated; resources flow into these sectors altering the structure of production and investment. Mises describes the effect:
“The additional quantity of money does not find its way at first into the pockets of all individuals; not every individual of those benefited first gets the same amount and not every individual reacts to the same additional quantity in the same way…The additional amount of money offered by them on the market makes prices and wages go up. But not all the prices and wages rise, and those which do rise do not rise to the same degree.
“If [for instance] the additional money is spent for military purposes.. the prices of some commodities only and the wages of only some kinds of labor rise, others remain unchanged or may even temporarily fall. They may fall because there are now on the market some groups of men whose incomes have not risen but who nevertheless are obliged to pay more for some commodities, namely for those asked by the men first benefited by the inflation. Thus, price changes which are the result of the inflation start with some commodities and services only, and are diffused more or less slowly from one group to the others. It takes time till the additional quantity of money has exhausted all its price changing possibilities..But even in the end the different commodities are not affected to the same extent. The process of progressive depreciation has changed the income and the wealth of the different social groups” [Emphasis added](Mises)
Over time, the new money permeates deeper into economy but even when the process come to a halt it is unlikely to have affected all economic agents equally and proportionately; the condition necessary for neutrality. The eventual changes to prices are also unlikely to be uniform or proportionate.
That money is not neutral in the long run is supported by empirical evidence. Moreira et al (2016) study the effect of a change in the quantity of money on relative prices in the U.S. economy for the period 1959 to 2013. They find that money is not neutral in a non-traditional sense because a change in the money supply disturbs relative prices and consequently, the allocation of resources in the economy. They also find that change of money supply not only affects relative prices but also affects the inflation rate and real variables, such as investment, natural rate of unemployment and potential GDP, through the change in relative prices.
Further empirical evidence for the Cantillon effect is available in the variability and skewness in price increases. As Sieroń notes:
“the Cantillon effect is empirically confirmed by two characteristics (aspects) of inflation (Bilo, 2013). First, the increase of money supply and the general price level is tied to increased variations in relative prices (Fischer, 1981), which is consistent with predictions stemming from the sequential process of spreading new money through the economy and gradually raising prices. Second, the price increase is significantly skewed (Vining and Elwertowski, 1976), i.e. the increase in the general price level is generally caused by significant increases in the prices of a small group of goods and services, while the prices of most goods and services change less than the general price level. This is in line with the predictions that new money is introduced into the economy through specific channels”. (Sieroń, 2019)
A good example of this was seen in Sri Lanka during 2024. Although the overall price index was declining, this was driven largely by reductions in energy prices partly due to the stronger rupee. Other categories continued to show positive inflation. Not all these movements were due to monetary factors but they nevertheless underline the fact that prices changes are neither uniform nor proportional.
Other studies confirm the link between inflation and relative price variability. Lamont and Debelle (1996) examine a cross-section of 627 US cities for the period 1954-86 and find a strong correlation between inflation and relative price variability. Because their study focuses on cities, it controls for nationwide shocks including changes in monetary policy (different cities do not have different monetary policies) and oil prices.
Since new money does not affect all businesses or people proportionately and at the same time:
1. it leads to changes in the distribution of income and wealth within society and
2. a reshuffling of relative prices and production leading to changes in resource allocation and production structure.
These will be discussed in the section of the negative effects of inflation.
[Appendix 1 on the Australian gold discoveries provides an illustration of the changes to the production structure following changes in money supply and Appendix 2 on the case of Hugo Stinnes gives an example of the distributional outcomes of inflation.]
5. Monetary neutrality and long term distortions
In Sri Lanka, new money enters the economy primarily through the banking system, when the CBSL conducts open market operations or engages in foreign exchange transactions (purchases or swaps FX) with banks. This money finds its way into the economy through the bank lending channel; through the firms and individuals that utilise bank credit. It then flows through those particular sectors, depending on the purposes for which money is borrowed and the spending patterns of recipients; sequentially changing, demand, relative prices and the investment structure.
The increase in money supply distorts both resource allocation and investment. Because new money does not enter uniformly, only certain sectors are benefited which draws resources into those sectors. Because monetary policy works through interest rates, it distorts both investment and savings.
Under monetary stimulus, the interest rate may fall below its natural rate. The danger with holding the interest rate below that natural level is the distortion of investment and consumption. Mislead by the lower rate of interest, investors may embark on projects that were otherwise not viable, hence prima facie, suboptimal. With rates low, households may also prefer to consume rathe than save, so savings may even fall even while investment is rising, creating imbalances within the economy.
The volume of investments increases but this no longer reflects underlying time preferences and real savings. The balance of investment across the various sectors of the economy is also affected; the sectors benefiting from new money attracting proportionately more.
While capital projects that may be embarked on at an artificially low rate may add to the capital stock, there may be no underlying demand for these in the absence of the monetary stimulus resulting in mal-investment or suboptimal projects. The resulting capital structure is thus distorted. When the monetary stimulus fades, the real resources to complete these projects may be lacking leading to, in the worst instance, widespread busts that can threaten the stability of the banking system.
Any change to relative prices caused by the effects of inflation does not represent real changes in supply or demand. The changes in relative prices will however lead to reallocation of resources and therefore suboptimal. In the Sri Lankan context credit allocation through state or politically connected banks may add further distortions.
The experience of housing markets offers a good example. Lower borrowing costs make apartment and real estate projects appear increasingly viable by expanding the pool of potential buyers, encouraging developers and investors to bid up land prices. As property prices rise, collateral values also increase, enabling banks to expand credit further and reinforcing the boom. This mechanism was visible in Japan’s 1980s property bubble and has been examined more broadly by the Swiss National Bank in a study covering 14 OECD countries. The study found a “strong link between low interest rates and housing bubbles”, with the effect becoming especially pronounced when interest rates remain “too low for too long”.
Thus, under the effect of stimulus there may be both over-investment and over-consumption (ie expenditure that exceeds the economy’s underlying real savings and productive capacity) sending the economy into imbalance. In national accounting terms, the imbalance between savings and investments will be reflected in the current account (external sector). As long as the flow of new money continues, the imbalances widen and accumulate in an expanding current account deficit. Over time, this can reduce the resources available for external debt service and increase the risk of default.
In simple terms, the infusion of new money creates new demand for goods, but the supply of goods in the economy cannot adjust immediately. Expanding productive capacity takes time: it may take years to build a factory or months to increase output. However, the additional monetary demand arises almost immediately once the new money reaches consumers and businesses. The increased demand will therefore be met partly by diverting goods and resources away from other domestic activities, disturbing the existing structure of production, while any shortfall will be met through imports.
Persistent current account deficits that culminate in a BoP crises have been a feature of Sri Lanka’s post-independence economy, although these were absent during the era of the currency board (1885-1949). [Under a currency board money creation is tied to foreign reserves, so credit expansion cannot continue independently of external conditions. When external deficits emerge, reserves fall and domestic liquidity tightens, which reduces demand and helps restore balance. In this way, periods of excess demand tend to correct themselves rather than build up into larger imbalances.]
6. Negative consequences of inflation
The primary costs of inflation manifest through Balance of Payments (BoP) crises, resource misallocation and redistributive effects.
In the literature, three main approaches have been advanced to explain balance of payments problems: the elasticities approach, the absorption approach and the monetary approach. The elasticities approach focuses on the trade balance through exchange rates and relative prices; the absorption approach focuses on the current account through the relationship between domestic expenditure and output, while the monetary approach focuses on the overall balance of payments through the interaction of money demand and supply.
The elasticities and absorption approaches provide useful, but partial insights into specific components of the external accounts. This essay adopts the monetary approach to the BoP (MABP), associated with Harry Johnson because it offers the most comprehensive framework.
From the perspective of the MABP when the CBSL stimulates the economy through an expansion of money and credit (thereby lowering interest rates), new purchasing power is created without a prior increase in real savings. This allows consumption and investment to rise simultaneously, with part of the additional demand spilling into imports. At the same time, credit expansion can alter relative prices and investment patterns, increasing demand in import-intensive sectors.
There is typically a lag between monetary expansion and its impact on consumer price indices but the foreign exchange market reacts more quickly. Consequently exchange rate pressures may emerge before they are reflected in measured inflation. By the time monetary policy is tightened, the currency may already be under pressure. If the resulting reserve losses and monetary contraction are resisted through further liquidity injections to maintain targeted interest rates or policy rate corridors, the imbalance will intensify and culminate in a balance of payments crisis.
Recent experience illustrates this dynamic. Liquidity was expanded during the second half 2024 via open market operations and in 2025, via foreign exchange purchases/swaps. The exchange rate depreciated from around LKR 290 per USD in November 2024 to approximately LKR 317 by April 2026, a decline of about 9%. Yet, headline inflation remained low at 2.2% YoY in March 2026. This divergence indicates that exchange rate pressures can materialise well before they are captured in measured inflation.
It is also notable that exchange rate pressure emerged, even while the fiscal position has improved significantly, which weakens the argument that external imbalances are primarily driven by fiscal excess. Instead, the evidence points to the role of broader monetary conditions. Even in the absence of fiscal monetisation, an expansion of domestic liquidity can sustain levels of expenditure that exceed the economy’s real resource base, with the resulting imbalance reflected in increased demand for imports and foreign exchange.
Given the emphasis on the exchange rate as a “shock absorber” and the “first line of defence” it is useful to contrast the monetary approach with the elasticities approach, which relies on exchange rate adjustment as a mechanism for restoring external balance.
Balance of payments crises
Under the conventional framework, central banks often operate under the assumption that domestic and external objectives can be separated. Interest rates are used to target domestic inflation, while a flexible exchange rate is expected to correct external imbalances. Thus the impact of monetary policy on foreign reserves and the BoP may be overlooked.
The Marshall Lerner Condition
Within the elasticities framework, the effectiveness of exchange rate adjustment depends on the Marshall–Lerner condition: depreciation will improve the trade balance if the sum of the price elasticities of exports and imports exceeds one.
However in countries with an inelastic trade basket this condition may not hold in the short to medium term. A study by Chandraratne et al (2020) which examined the applicability of ML condition to Sri Lanka using data from 1980 to 2018 found that the combined export and import price elasticity was below one. This suggests that in the short to medium term, Sri Lanka’s trade balance is likely to deteriorate following a depreciation.
Several structural features explain this outcome:
Industrial exports (garments, value added rubber – gloves, tyres etc) account for around 77% of merchandise exports. Although currency depreciation may improve price competitiveness, expanding exports of complex value-added products is not simply a matter of lowering prices. Such products depend on established buyer–seller relationships, integration into distribution networks and long procurement cycles. Even where margins improve, converting that price advantage into higher volumes can take time. A World Bank study found that in Malawi a10 percent depreciation increased exports by by only 7.7% after one year, while in Pakistan a 10% depreciation increased exports by only 6.2% after one year.
Similar problems apply to services such as tourism, IT/BPO where expansion depends on skilled labour availability, marketing reach and international perceptions. These limit the speed at which volumes can respond to exchange rate movements.
Agricultural exports (tea, coconut, spices etc) traded as bulk commodities in more standardised markets may respond better to currency depreciation. It is easier to place additional quantities of black tea or desiccated coconut through auction systems or commodity brokers than to secure new apparel contracts. However these products accounted for only around 23% of merchandise exports. Supply also matters; production of tea or coconut cannot increase rapidly even if new markets are available.
On the import side, a significant share consists of industrial inputs (55% including fuel) investment goods (19%, including machinery and construction materials); food (10%) and other consumer goods (16% including medicines). Many of these are essential to production or consumption and cannot be reduced quickly. Exporters and domestic producers rely on many imported inputs including fertiliser. As a result currency depreciation may raise import costs without proportionately reducing import volumes.
The limited applicability of the Marshall-Lerner condition in Sri Lanka reduces the effectiveness of the elasticities approach in explaining external adjustment. However, even if the condition held, the elasticities approach would remain incomplete because it focuses on relative price adjustments omitting the underlying monetary conditions driving the demand for foreign exchange.
Moreover, the pattern of domestic demand also matters. In Sri Lanka, monetary expansion flows largely through the banking system, with credit growth concentrated in sectors such as construction, infrastructure, trade and consumption. These sectors tend to be import sensitive. When credit expands, demand tends to shift towards these activities increasing the economy’s import content. Thus external pressures can thus build quite quickly, even when domestic inflation remains moderate.
While the absorption approach correctly identifies that current account deficits emerge when domestic expenditure exceeds output it does not fully explain the mechanism by which this excess is financed. The absorption approach is useful for analysing demand-driven deficits but is incomplete without the monetary lens that explains how domestic credit expansion creates excess purchasing power that manifest as reserve losses or exchange rate pressure.
Therefore, even within the conventional framework, a flexible exchange rate may not be sufficient to correct BoP imbalances in the short to medium term if domestic monetary conditions remain expansionary.
If monetary policy is not tightened, the imbalances accumulate over time, culminating in a BoP crisis. While capital inflows such as IMF loans may temporarily finance such imbalances, they do not eliminate the underlying monetary disequilibrium. External borrowing may temporarily sustain expenditure at levels that are inconsistent with the economy’s real resource base, delaying the eventual adjustment which will be worse because the imbalances have been allowed to widen.
The IMF has its own version of the monetary approach, the Polak model developed in the 1950’s. This has been recently tested in study covering 11 West African countries (2005-2020) and found to be largely valid in explaining the BOP dynamics of those countries despite the absence of fixed exchange rate regimes. Similar results were obtained when tested on Indian Data (1971-2009).
The older monetary logic embedded in IMF financial programming seems more consistent with Sri Lanka’s experience. The previous monetary law reflected this more holistic approach and mandated the CBSL to maintain both economic and price stability. As Dr Wijewardene explains:
“…if you have only price stability, then you would fall into the trap of attempting to stabilise a price index which is not what is meant by price stability, in the context of a Central Bank. The attainment of price stability for a Central Bank means the elimination of both excess demand and excess supply in the market so that the market is free of potential inflationary or deflationary pressures. Such an equilibrium will help the country to maintain a balance in the balance of payments and thereby stability in the exchange rate” (Wijewardene, 2026)
BoP crises are socially disruptive and economically costly. They are typically associated with sharp contractions in output, businesses which were previously viable suddenly face difficulty. The stabilisation measures that follow; fiscal and monetary tightening, slows growth and reverses much of the earlier stimulus driven expansion.
A study covering 32 emerging market economies and 78 crisis episodes between 1975 and 1997 estimated cumulative output losses from currency and BoP crises at 5-8% over a two to three year period.(Hutchison and Neuberger, 2001).
Foreign debt
These external pressures are magnified when a significant share of public debt is denominated in foreign currency. Foreign debt (including SOE debt and FX denominated local debt) accounts for about 40% of Sri Lanka’s total debt. Depreciation increases the rupee value of foreign debt, raising debt service costs. The government must use tax revenues generated in rupees to buy foreign exchange to service foreign debt. When credit is expanding under the effects of stimulus, collecting FX becomes harder because the Treasury must compete with importers for dollars.
As the currency depreciates, servicing foreign debt becomes more difficult. Eventually the government ends up having to borrow more foreign currency debt to service the old debt, increasing the burden. If the currency undergoes a sudden collapse the problem balloons.
Misallocation of resources
In a market economy, the interest rate performs a central coordinating function.
“the interest rate is the key price in a market economy. While other prices affect the allocation of resources in the horizontal dimension (between sectors or production processes), the interest rate determines the intertemporal allocation of resources (in the vertical dimension). Since all production processes take place over time, the interest
rate not only affects the profitability of the investment, but also the volume and especially the structure of production”(Sieroń, 2019).
The natural level of interest rates depends on a number of factors including the supply and demand of savings. The return available on investments will determine the maximum that entrepreneurs are prepared to pay to borrow funds, while the individual time preference of savers will determine the minimum they will require to defer immediate consumption in favour of savings. The interaction of these forces will determine the natural rate of interest.
Under an inflation targeting regime, monetary policy operates through adjustments to short term interest rates and may lead to policy rates that deviate persistently from the natural rate.
When the interest rate is below the natural level it leads to the distortion of investment and consumption. Investors may embark on projects that appear viable under low financing costs which may not be sustainable once monetary conditions normalise. Households may devote more resources to current consumption, reducing savings within the economy. Over time, the imbalance between savings and investment will grow and the resulting capital structure is distorted, no longer reflecting underlying time preferences.
Capital projects are not homogeneous. Projects involve assets specific in particular sectors and stages of production. Because of the specificity and long-lived nature of the investments errors induced during monetary accommodation cannot be easily undone. When monetary policy is tightened some projects may no longer be viable, be halted halfway or operate below capacity. The cost of such adjustments is not merely short-term but represent long term misallocation of capital.
The misallocation is not only confined to investment decisions. Prices serve as “signals”, shaping decisions. In effect, inflation introduces “noise” that interferes with the “signal”. The flow of new money will draw resources into particular sectors that benefit from it an the expense of others. Prices distorted by inflation impede efficient resource allocation.
The orthodox view assumes that such distortions are temporary and largely reversible once inflation stabilises. However studies show that even low inflation can generate relative price dispersions. A study by the ECB which focused only on sticky prices (and not investment effects) found that even in the low-inflation environment that prevailed before 2022, the efficiency cost of misallocation amounts to roughly 2% of GDP.[Emphasis added]
Redistribution
“Money is only important for what it will procure. Thus a change in the monetary unit, which is uniform in its operation and affects all transactions equally, has no consequences…..[but]as we all know, when the value of money changes, it does not change equally for all persons or for all purposes. A man’s receipts and his outgoings are not all modified in one uniform proportion. Thus a change in prices and rewards, as measured in money, generally affects different classes unequally, transfers wealth from one to another, bestows affluence here and embarrassment there, and redistributes Fortune’s favours so as to frustrate design and disappoint expectation.”(Keynes, 1923)
Spending patterns, consumption baskets and savings composition vary among different socio-economic groups. Uneven changes in prices impact different social groups in different ways depending on:
Expenditure patterns: the composition of the spending basket
The composition of savings: money savings are directly affected but real assets are less affected.
Incomes – The adjustment of incomes depends on skills scarcities and bargaining power.
In general, redistribution takes place:
From late recipients of new money to early recipients because early recipients are able to use the money before prices rise. (Banks are early recipients so they benefit at the expense of businesses. Businesses that borrow and have pricing power can benefit at the expense of consumers).
From fixed incomes to flexible incomes. (Those who ae able to adjust their incomes quickly are able to protect themselves).
From savers to borrowers (as the real value of both savings and debts will fall).
These are discussed below.
Expenditure Patterns:
Low-income households tend to spend a higher fraction of their budget on necessities such as food while higher income households spend more on discretionary items. When prices rise, higher income households can cut back on spending on discretionary items (or fall back on their savings) to preserve their spending on necessities but poor households have less room to do so. Moreover, because price increases are not uniform, the impact varies depending on the spending basket.
In Sri Lanka the increase in food prices affect the poor more because the they allocate more of their income to food. During the peak of the crisis in September 2022 food price inflation rose to 94.9% but the overall CCPI increased by only 69.8%.While both supply and demand factors will affect prices a study found that monetary expansion was the key determinant of food inflation in Sri Lanka.
Therefore it is not surprising that levels of poverty and malnutrition increased during the crisis: the cost of living rose but incomes adjusted more slowly. Three years later, although declining, they remain high:
“poverty, although declining, remains twice as high as in 2019. The labor market has been slow to recover, and many households have yet to regain livelihoods lost during the crisis. An additional 10 percent of the population lives just above the poverty line, and malnutrition remains a serious issue, especially among vulnerable groups.” (World Bank, 2025)
Savers and borrowers
Higher income groups are more likely to own real assets (property or claims to property such as shares) which provide a hedge against inflation or may even appreciate. Land in Sri Lanka seems to have been an effective hedge during the crisis. Instances where values of real assets grow faster than inflation are not unknown. However the poor, whose savings are mainly in the form of money assets (bank deposits etc) experience direct losses as the purchasing power of money diminishes.
Borrowers, including the largest; the government benefit as the real value of their debts fall but their gain is at the expense of savers.
Incomes
Those who possess in-demand skills and have flexible incomes; for example doctors or consultants are able to raise fees quickly. Due to the lack of pubic transport taxi fares may also adjust rapidly. For those on fixed employment contracts salaries typically rise only after a lag and may not keep up with inflation.
Income depends on skills but not all skills are valued equally. A crisis that squeezes household budgets will re-order existing spending priorities which in turn affect the incomes of others. For example, the author found that certain categories of teachers – in Western Music or English Literature who used to tutor students find that fewer parents are able to afford tuition-and what money is available for tuition is spent on subjects such as maths or science. University teacher salaries seem to have lagged leading to a number migrating.
This is also true for informal sector workers. The fact that incomes do not keep pace with inflation may be inferred from surge in migration post crisis. When wage adjustments do not keep up with inflation people migrate. Outward migration surged to around 300,000 in 2022, and stayed at that level every year since. Prior to the crisis, outward migration was around 200,000 annually.
Retirees and others on fixed income experience little adjustment and so will be much poorer.
From later recipients to early recipients.
The winners are those who can use the new money first, because at this point in time the money prices of the other goods are still relatively low. Due to these expenditures, prices and incomes gradually increase, and in this way the new money spreads through the economy. The losers of this process are those who only later – or last of all – enjoy a higher money income. This is because they are already having to pay the higher prices, created by the increased money expenditure of the early users of the new money, out of their previous lower income (Hülsmann, 2013)
Banks, which are generally the first recipients of new money generally benefit. Sieroń attributes relative the growth of the financial sector over the last several decades in developed countries to credit expansion and transactions with the central bank. He notes:
“The relative benefits of the financial sector from credit expansion and being one of the first recipients of newly created money may explain the significant increase in the financial sector’s share of GDP in the United States over the last several decades (Greenwood and Scharfstein, 2012)…..
..In the years 1980–2007, the share of the financial sector in US GDP grew much faster than between 1950 and 1980. As a consequence, the share of the financial sector in GDP increased from 4.9% in 1980 to 7.9 % in 2007,4 while the stock market capitalization increased from 50% to 141% GDP” [Note: Monetary expansion accelerated after the breakdown of Bretton Woods in 1971] [Between 1959 and 1971, the monetary base grew on average (geometric average) by 4.62% annually, while M1 grew by 3.72%. In the years 1971–2013, it was already 9.26% and 5.97%, respectively (Sieroń, 2019).]
The Bank of England (2012) noted that the richest households benefited the most from the increase in asset prices, which resulted from the bank’s quantitative easing program (in 2011, the richest 5% held 40% of financial assets kept outside of pension funds). [The BoE’s QE programme created new money to buy securities in the open market]
Banks lend the money to their customers. Businesses that are able to borrow and expand benefit. Once prices start rising, businesses with pricing power are to pass on increased costs to consumers, who lose out. Individuals who borrow are also able to use new money, before general prices increase as the story of Hugo Stinnes illustrates (refer Appendix 2).
In general the poor lose more from inflation due to the compositions of their savings and patterns of expenditure.
Stephen King sums up the effects:
“Winners and losers emerge, some on a temporary basis, some permanently. Those who lose observe with increasing anger the arbitrary gains made by the lucky winners. Trust across society begins to erode. In effect, inflation works as a mechanism arbitrarily and unfairly to take from some, even while giving to others. Those with only limited cash savings –notably the poor and pensioners – tend to be hit particularly hard, lacking as they do the financial depth and knowledge to ‘protect’ their savings. Those who have borrowed heavily –governments, house purchasers, some businesses – may eventually emerge as winners: even if the cost of borrowing rises, their debts will likely diminish over time relative to their now inflating incomes. Unionised labour – able to strike at the drop of a hat – can often succeed in negotiating an ‘inflation-busting’ wage increase. Those working on their own or in a small business are more likely to find their wages simply can’t keep up. Dominant companies can easily pass cost increases (and more) onto their customers, but suppliers to those companies or those who find themselves in some other highly competitive
environment will fare less well”.
The redistributive effects are generally acknowledged but are often viewed as transitional on the assumption that money is neutral in the long run. In theory, once prices and wages fully adjust, real incomes should be restored but as discussed previously, the assumptions on which neutrality is based are unlikely to hold. In the real world incomes will not always change proportionately and uneven price increases have different impacts on different social groups.
7. Conclusion
The case for a positive inflation target depends critically on the assumption of monetary neutrality: that increases in the money supply affect only nominal variables and leave real economic outcomes unchanged over time.
That changes in money supply cause real changes is not questioned, indeed if it did not cause real changes, monetary policy would be ineffective. Moreover, the real changes are brought about precisely because distribution of new money is uneven; if the increase in money supply changed the cash balances of all economic agents simultaneously; uniformly and proportionately, it would have minimal real effects.
Thus the unequal distribution of new money quickens economic activity in particular sectors, drawing resources into those sectors, changing relative prices and resource allocation. As these changes are driven by the monetary impulse rather than the underlying preferences and tastes, the resource allocation diverges from the real underlying economic forces. These distortions include changes to the structure, composition and quantum of investment. Naturally, it also has redistributive effects. Moreover, monetary disequilibrium also triggers periodic balance of payments crises resulting in large output losses.
Conventional macroeconomic theory recognises that monetary expansion may generate short-term distortions including exchange rate pressures and external imbalances but assume these effects are transitory and largely self-correcting under flexible exchange rates. This essay has argued that these assumptions do not hold in practice.
It is admitted that inflation cannot create long term growth but it is believed to deliver some short term benefits in smoothening output and easing adjustments. In the short run, inflation can indeed provide an illusion of growth, more activity takes place and it is tempting to continue this. The ill-effects appear later.
The current difficulties being experienced with the exchange rate should serve as a warning to policymakers. Under the influence of liquidity injections since mid 2024 the imbalances were building and the currency had started to slide since late 2024. The external shock only worsened the problem, it was not the primary cause.
If, instead of being assumed away, the full costs of inflation are weighed against the purely short-term benefits that it may deliver, the case for positive inflation is difficult to sustain.
The CBSL’s stated mandate is centred on maintaining domestic price stability and financial system stability. These could be achieved and external stability maintained with an inflation rate close to zero.
However, the CBSL has set its inflation based on a staff study that argued that GDP growth has an increasing relationship with inflation when inflation is around 4-7 per cent. In determining the desired inflation target, the output gap - the difference between an economy’s actual and potential output or growth has been a key consideration.
Growth is not a specified CBSL objective. The deviation from the specified objectives to include growth in the inflation target seems to be on the basis of an additional ambiguous phrase in the statement of objectives: “with a view to encouraging and promoting the development of the productive resources of Sri Lanka”.
BoP crises cause crippling economic disruptions so avoiding monetary imbalances that culminate in BoP crises should be a priority. This is entirely consistent with the objective of promoting sustainable development. Maintaining external stability is a necessary condition for domestic stability.
The Harvard CID study on Sri Lanka noted that:
“The initial analysis found that recent growth and the sustainability of growth moving forward are constrained by weakness in Sri Lanka’s balance of payments, where a trade imbalance combined with low levels of foreign direct investment effectively puts a speed limit on economic growth.”(Hausmann, 2016)
Since growth is constrained by the balance of payments, more sustained growth means avoiding BoP problems which implies a limited role for monetary policy.
The CBSL should therefore be restricted to its stated objectives of price stability and financial system stability both of which would be achieved through monetary stability. Maintaining monetary stability would require a low inflation target, close to zero. A higher target is necessary only if the CBSL wishes to manage the output of the real economy. As argued in this essay it is the attempts manage economic output that result in unintended and harmful outcomes.
While a zero inflation target is desirable, practical difficulties in measurement may preclude its adoption. In any case, inflation cannot be steered with pinpoint accuracy, or measured precisely.
In difficult global environment, subject to unexpected political and economic shocks, prudence should be the guiding principle in selecting a suitable target. Dr Wijewardene has made a good case for a 2% inflation target for Sri Lanka on the basis of total factor productivity growth during 1980-2019.
Further, given the long and variable lags between a monetary policy impulse and its eventual effects on the economy, excessive credit growth can generate imbalances, including external pressures in the balance of payments before policymakers can fully observe and respond to the consequences.
This essay recommends selecting a 2% ceiling for inflation. A ceiling, rather than a target, reduces the risk of policy being used to stimulate activity while still accommodating measurement uncertainty.
The CBSL should ensure that inflation does not exceed 2%, any rate below this would be acceptable. The CBSL will no longer need to explain to Parliament why an inflation target is undershot, it would only need to explain itself if it breaches the upper limit.
As William Poole and David C. Wheelock of the Federal Reserve Bank of St Louis note
“However, a growing number of economists today believe that monetary authorities can best promote financial stability and economic growth by making a firm commitment to maintaining price stability. There is little evidence that expansionary monetary policy can increase employment or economic growth, except perhaps for brief periods, and there is no evidence that inflation fosters financial stability. On the contrary, history is full of examples of how an unstable price level can wreck a financial system and harm the economy.”
Appendix 1: The Cantillon Effect -Australian gold discoveries
The far-reaching changes wrought on the production structure from changes in relative prices originating in an increase in money supply are difficult to grasp in abstract terms. J.E. Cairnes account of the Australian gold discoveries in the 1850’s provides a good historical illustration of this phenomenon.
When gold was discovered, it entered the economy at a specific point: the goldfields. Ordinary worker could earn £1 (20 shillings) a day panning gold, instead of 3–5 shillings a day elsewhere. In economic terms labour productivity rose dramatically in mining. Workers abandoned, farms, sheep stations and workshops. Entire industries temporarily collapsed. Importantly, this real reallocation occurred before any general increase in prices (inflation).
Wages rose everywhere, even outside mining, benchmarked against gold-field earnings but the effects were uneven. Local services near goldfields (supplying food and housing to miners) raised prices rapidly as demand and income had surged locally.
Export industries (especially wool) could not do so because prices were set in global markets. Europe would not pay double for Australian wool. Exporters faced higher costs, fixed selling prices, and falling profits resulting in changes in the structure of production. Sheep farming before gold was primarily for wool, meat was almost worthless. After the gold discoveries, the population exploded due to immigration. Meat prices quadrupled and meat became the main profit source with wool as a by-product. The same sheep and land were used but changes in relative prices changed the economic logic of production.
Global prices rose slowly because Australian gold output was small relative to world supply. Yet within Australia domestic wages and prices rose rapidly. Australian agriculture had to compete with mining for labour but world food prices, especially exportable produce did not rise proportionately. As a result agricultural production declined with only the very best land remaining viable. Previously a food exporter, Australia began to import over half its food.
The end result was not a temporary disruption but permanent change in the structure of production caused by changes in relative prices.
This episode illustrates the fact that monetary expansion does not simply raise the price level. It alters relative prices, redistributes income and changes investment incentives even before general inflation emerges. Many of these adjustments persist long after aggregate prices stabilise.
Appendix 2: Cantillon Effects and Redistribution: – The Case of Hugo Stinnes
In the early 1920s, Germany faced catastrophic hyperinflation when the German currency plummeted from 7,500 Reichsmarks to the dollar to a rate of 2.5 trillion, leading citizens to resort to bartering goods for essential items.
Living in hyperinflationary Germany was very hard, unless you had a good supply of dollars. For civil servants, whose salaries never kept up, and savers, whose holdings shrank to nothing, it was a slide into poverty and worse. Manual labourers were better rewarded than white-collar workers. Landlords earned a pittance in rent. Pensioners starved. House-buyers had a better time of it; at least their mortgages shrank to nothing. For the quick- witted it was a game of barter and raiding the countryside where most people at least were not starving. Two million migrated back to the land from German towns. Fat cats thrived by trading property and black-market goods and so did a handful of industrialists.
Hugo Stinnes built a vast industrial conglomerate during this period, offering a good illustration of how inflation; while impoverishing many, benefit some; altering the distribution of wealth. While middle-class Germans watched their savings evaporate between 1919-1923, Stinnes borrowed heavily in marks and bought real assets, coal mines, steel mills, shipping companies, newspapers; repaying the loans with nearly worthless currency later.
As the value of the mark collapsed, inflation steadily eroded the real burden of his debts, while the underlying value of his assets proved far more resilient. By the early 1920s, he controlled a vast network of industrial enterprises spanning multiple sectors.
This episode reflects a broader dynamic often associated with the Cantillon effect: newly created money does not enter the economy evenly. Those with early access to credit, typically large firms and financial intermediaries are better positioned to acquire assets before prices fully adjust. Meanwhile, wage earners and savers, whose incomes and holdings adjust more slowly, bear the cost through declining purchasing power.
Stinnes understood this and positioned himself near the source of the new money, borrowing from banks flush with new money and investing in productive capacity that couldn’t be printed away. As one of Germany’s most powerful industrialists he had no difficulty in borrowing.
Stinnes benefitted from the monetary environment. Inflation did not affect all participants equally; it redistributed wealth toward those able to leverage debt and acquire real assets, while eroding the position of those holding cash and fixed claims.
Appendix 3 : The Money Illusion – excerpt from Irving Fisher
“Money Illusion”; that is, the failure to perceive that the dollar, or any other unit of money, expands or shrinks in value. We simply take it for granted that “a dollar is a dollar”-that “a franc is a franc,” that all money is stable…
Almost everyone is subject to the “Money Illusion” in respect to his own country’s currency. This seems to him to be stationary while the money of other countries seems to change. It may seem strange but it is true that we see the rise or fall of foreign money better than we see that of our own.
For instance, after the War, we in America knew that the German mark had fallen, but very few Germans knew it. This was certainly true up to 1922 when with another economist (Professor Frederick W. Roman) I studied price changes in Europe. On my way to Germany I stopped in London and consulted with Lord D’Abernon, then British Ambassador to Germany. He said: “Professor Fisher, you will find that very few Germans think of the mark as having fallen.” I said: “That seems incredible. Every schoolboy in the United States knows it.” But I found he was right. The Germans thought of commodities as rising and thought of the American gold dollar as rising. They thought we had somehow cornered the gold of the world and were charging an outrageous
price for it. But to them the mark was all the time the same mark. They lived and breathed and had their being in an atmosphere of marks, just as we in America live and breathe and have our being in an atmosphere of dollars. Professor Roman and I talked at length with twenty-four men and women whom we met by chance in our travels in Germany. Among these only one had any idea that the mark had changed.
Of course, all the others knew that prices had risen, but it never occurred to them that this rise had anything to do with the mark. They tried to explain it by the “supply and demand” of other goods; by the blockade; by the destruction wrought by the War; by the American hoard of gold; by all manner of other things, exactly as in America when, a few years ago, we ourselves talked about the “high cost of living,” we seldom heard anybody say that a change in the dollar had anything to do with it.
I remember particularly a long talk with one very intelligent German woman who kept a shop in the outskirts of Berlin. She gave all kinds of trivial reasons for the high prices. There was a grain of truth in some of them, just as there is a grain of truth in the idea that a small part of the seeming motion of the stars is real. But the main fact of the tremendous increase in the volume of “marks” and of the action of this paper money inflation on prices was not eyen glimpsed by the German shop woman.
For eight years she had been victimized by the changing mark but had never once suspected the true cause-inflation. When I talked with her the inflation had gone on until the mark had depreciated by more than ninety-eight per cent, so that it was only a fiftieth of its original value (that is, the price level had risen about fifty fold), and yet she had not been aware of what had really happened.
Fearing to be thought a profiteer, she said: “That shirt I sold you will cost me just as much to replace as I am charging you.” Before I could ask her why, then, she sold it at so low a price, she continued: “But I have made a profit on that shirt because I bought it for less.”
She had made no profit; she had made a loss. She thought she had made a profit only because she was deceived by the “Money Illusion.” She had assumed that the marks she had paid for the shirt a year ago were the same sort of marks as the marks I was paying her, just as, in America, we assume that the dollar is the same at one time as another. She had kept her accounts in what was in reality a fluctuating unit, the mark. In terms of this changing unit her accounts did indeed show a profit; but if she had translated her accounts into dollars, they would have shown a large loss, and if she had translated them into units of commodities in general she would have shown a still larger loss-because the dollar, too, had fallen.
Link to Fisher’s The Money Illusion
https://ia601407.us.archive.org/34/items/in.ernet.dli.2015.25405/2015.25405.The-Money-Illusion-1928.pdf
Note on Money Illusion: Empirical evidence confirming its existence was provided by Shafir, Diamond, and Tversky (1997). Their study demonstrated that individuals systematically think in nominal rather than real monetary terms, affecting behaviour in wage contracts, pricing decisions, and economic discourse.
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