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Sri Lanka fiscal stimulus to close output gap

ECONOMYNEXT – Sri Lanka’s sweeping tax cuts are are fiscal stimulus will close a “persistent output gap”, seen in recent years and transfer cash to private hands from unproductive state spending, the government has said.

“The switching of resources from unproductive public expenditure to the private firms and individuals will be growth friendly in a context where there has been a persistent output gap,” the Finance Ministry said.

“Higher growth will have a positive impact on the overall debt dynamics of the country as well.”

That a lower tax take will boost economic activity with private individuals making the best decisions is well accepted classical economic principle, rather than bureaucrats who play with other people’s money to boost salaries, subsidies or expand the public sector.

Sri Lanka was given clues to calculate a so-called potential output by the International Monetary Fund, which now seems to serving one de facto target or goal in a ‘flexible’ inflation targeting framework and the fiscal stimulus.

Under flexible inflation targeting a mis-mash of targets are chased by the central bank, critics have said.

Under the current IMF program the exchange rate is targeted to prevent appreciation and collect forex reserves and the rupee is encouraged to fall under a downward only DMC (disorderly market conditions) rule forming de facto – if highly variable – external anchor.

Outside the program the Real Effective Exchange Rate Index was also targeted to depreciate the rupee even domestic credit was weak particularly in 2017.

Sri Lanka was first saying that potential output of the country was 5.75 percent, using econometrics.

In February 2019, Central Bank Governor Indrajit Coomaraswamy said the potential out was lowered to 5.0 percent.

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In 2018 April 2018 Sri Lanka cut rates and injected tens of billions of rupees of excess liquidity to money markets when 12-month inflation was 4.2 percent and so-called core-inflation was 6.1 percent in March.

It is not clear whether money was injected to target an output gap rather than inflation. In July/August money was also printed through the acquisition of dollars and rupee/dollar swaps.

In November 2018, when the external anchor came under pressure, from the monetary stimulus worsened by a confidence shock from a political crisis, rates were hiked when inflation had fallen to 3.3 percent and core inflation had fallen to 4.6 percent, apparently under ‘flexible’ inflation targeting.

Some classical economists have pointed out that the ‘Great Inflation’ of the 1970s and the collapse of the US dollar in 1971-73 was a result trying to target an output gap, ignoring that monetary nature of inflation (monetary policy neglect hypothesis) and focusing on incomes policy (wage spiral inflation) due to a belief in cost-push inflation.

Others such as Athanasios Orphanides, Simon van Norden have shown that it is difficult to estimate outut gaps in real time (also known as the output gap mismeasurement hypothesis), showing the deadly nature of econometrics. (Colombo/Dec22/2019)

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