Question

What do you mean by inflation? In an economy what factors influence the inflation the
inflation?

Discuss fiscal policies to contain inflation and explain how global economic is trend has
impacts on our economy.

Answer

In economics, inflation is a rise in the general level of prices of goods and services in an economy
over a period of time. Inflation reflects a reduction in the purchasing power per unit of money.
The inflation of a country is measured by calculating the inflation rate which is the annual
percentage change in consumer price index.

Various factors contribute to change the inflation rate of a country. Particularly the growth of
money supply, interest rates, budget deficit, depreciation of local currency against to dollar,
Gross domestic product (GDP), Gross national product (GNP), Balance of payment (BOP) to this
outcome.

After trade liberalization and open market oriented reforms Sri Lankan economy changed
drastically and during this period, the trend of inflation recorded in Sri Lanka has been highly
volatile and has emerged as the most common problem all over the country. According to the
Central Bank of Ceylon reports the inflation rate measured by the Colombo consumer price index
increased 16.6% in 1984 to 22.6% in 2008. In 2008 it has reported peak value of the inflation rate.
After that the inflation rate is dressing gradually and it reduced to one digit percentage valve
(less than 10%) and it is observed that during last two year period the inflation rate stable around
7%.

According to research carried out by economists, the broad money supply in the economy
increases by one percent that the inflation rate will also increase by 0.69 percent. And when the
Sri Lankan Rupee depreciates by one percent, inflation will increase by approximately 0.18
percent, which shows the importance of the exchange rate in the long-run inflation situation in
Sri Lanka. The result also reflects that an increase in the budget deficit is also contributing to long
run Inflation. It implies that when the budget deficit increases by one percent, the inflation rate
also increases by 0.55 percent. This result reflects the need to control the budget deficit in Sri
Lanka.

As mentioned above the factors influencing for inflation rate are changing acceding to global
economy. There are positive or negative impacts trends to local economy as well as inflation rate.

 Increasing of global fuel price

During past two decades the global fuel price increased at a higher rate. Price of crude oil barrel
has changed more than 500% during that period. In case of Sri Lanka all petroleum oil and gas
requirement is imported and in Sri Lanka more than 50% electricity power requirement has been
generated by petroleum oil and gas in addition to automobiles and industries. Thus Sri Lanka has
to spend the highest percentage of money from their GDP and earnings. Due to the political
instability in gulf region and political influence from western countries to gulf region it
fluctuations in global petroleum oil price are very high. This situation is badly affected to our
economy and caused to increase in the budget deficit, depreciation of local currency against to
dollar, decrease the Balance of payment etc…as a result of that inflation rate of Sri Lanka trend to
increase.

 Economic crisis in western countries.

Due to the western economics suffered downturn during last five years, western countries could
not financially support to third world countries as early also they have reduced their
investments.

Economic crisis in western countries also affect to tourism of our country, reduced the export
market especially garment products and increase the prices of import commodities from western
countries to our country. Therefore this situation caused to increase in the budget deficit,
depreciation of local currency against to dollar, decrease the Balance of payment etc…as a result
of that inflation rate of Sri Lanka trend to increase.

 High economic growth of some Asian countries especially China, India, Malaysia etc…

These Asian countries achieved several economic goals such as very high economic growth, low
inflation, innovation new products from research & development, providing whole world to
goods and services at a low price, etc… Sri Lanka imports most of goods such as food
commodities, automobiles, electronic products, construction materials & equipments and other
several consumable from the above countries. Since above countries provide goods at a low price
as mentioned above it caused to decrease in the budget deficit, reduce depreciation of local
currency against to dollar, and increase the Balance of payment etc…as a result of that inflation
rate of Sri Lanka trend to decrease.

 Political instability & civil wars in gulf countries and economic crisis in Europe.

According to the reports from central bank of Ceylon more than 2 million Sri Lankan people
work in overseas as foreign employers. Their contribution to our economy is very high. Their
earnings support to reduce the budget deficit, GNP and BOP. More than 75% Sri Lankan
employees work in gulf region countries and European countries but last five years period it is
observed that political problems and civil wars in several gulf region countries and economic
crisis in European countries. This unforeseen situation directly affected to our employees who
work in these countries and trend to reduce the employment opportunities. Therefore this
situation caused to decrease the earnings and increase in the budget deficit, decrease the Balance
of payment etc…as a result of that inflation rate of Sri Lanka trend to increase.

Finally increasing broad money supply, rising government budget deficit and exchange rate
depreciation appear to be the major determinants of inflation as they play a significant role in the
long run inflation equation. The results also reveal that there is a stable inflation function in the
long run in Sri Lanka and indicates the reliability of forecasting inflation using money supply
growth, budget deficit and exchange rate depreciation as key determinants. Further, the results of
this study emphasize the need to put in place a stable macroeconomic policy environment
relating to these variables in an effort to maintain price stability, since low inflation would
enhance economic growth.