Efficacy of Recent Monetary Policy in Sri Lanka

Abstract

Sri Lanka is an open and market-oriented lower middle income economy situated in South Asia. It is one of the fastest growing economies in Asia and developing world in the recent years. Sri Lankan economy has achieved 6.4 per cent growth over the period 2003 to 2012. At the same period the economy has experienced 10.4 per cent inflation. This paper studies efficacy of monetary policy in Sri Lanka to raise income and stabilizing price level in the recent period Q1: 2002-03 to Q4: 2013-14, when exchange rate has become more flexible. Empirical analysis has found that both income and price maintain long run relation with money, interest rate and exchange rate. Dynamics of such relations is studied by the estimation of vector error correction model which reveals that money supply causes a raise in income and price level. Depreciation of Sri Lankan currency depresses income and raises price level. A higher interest rate depresses income but stabilizes price level. Robustness of these findings is confirmed through the estimation of unrestricted vector autoregression model, the Wald test followed by impulse response functions and variance decomposition analysis. The findings testify for an effective monetary policy in Sri Lanka over the period more importantly, when the economy also has realized a gloomy environment of Global economic crisis 2008.

Keywords: Interest rate, Exchange rate, Money supply, Real income, Inflation

JEL Classification: E31, E52, C32