Sri Lanka’s debate over inflation 2: The folly of price cuts

Dec 03, 2009 (LBO) – In a bid to relieve the public of rising cost of living, the Government has reduced the import duties of ten leading food items and expected the market too to slash the prices. Artificial price reductions too lure central banks to an unwarranted complacency because the price indices on which they base their monetary policy do not record increases. This is because the price indices are calculated by official statistical agencies by using the artificially fixed prices and not the would-be market prices. It is, therefore, akin to suppressing the price indices by deliberate means.

Price Stickiness after Reduction of Duties and Taxes

Why don’t the prices fall as expected when the governments slash import duties or taxes? That is because the prices are determined by the interaction of two forces, namely, the demand force and the supply force, and the governments’ slashing of taxes could control only one these forces, namely, the supply force.

The intention of the government is to reduce the supply prices of the commodities of which the duties or taxes have been slashed. This intention is actually realised by a reduction in the wholesale prices of the commod