The Impact of Monetary Policy on Economic Growth and Inflation in Sri Lanka

Abstract

Based on a vector autoregressive (VAR) framework and utilising both recursive and structural specifications, this study analyses the effects of interest rate, money growth and the movements in nominal exchange rate on real GDP growth and inflation in Sri Lanka for the period from 1978 to 2005. The results of the recursive VARs are broadly in line with the established empirical findings, especially when the interest rate is considered the monetary policy variable. Following a positive innovation in interest rate, GDP growth and inflation decrease while the exchange rate appreciates. When money growth and exchange rate are used as policy indicators, the impact on GDP growth contrasts with established findings. However, as expected, an exchange rate appreciation has an immediate impact on the reduction of inflation. Interest rate innovations are persistent, supporting the view that the monetary authority adjusts interest rates gradually, while innovations in money growth and exchange rate appreciation are not persistent. Several puzzling results emerge from the study: for most sub-samples, inflation does not decline following a contractionary policy shock; innovations to money growth raises the interest rate; when inflation does respond, it reacts to monetary innovations faster than GDP growth does; and exchange rate appreciations almost always lead to an increase in GDP growth. The results from the semi-structural VARs, which impose identification restrictions only on the policy block, are not different from those obtained from recursive VARs. The results show that none of the sub-samples since 1978 can be identified with a particular targeting regime. In contrast, the interest rate, monetary aggregates and the exchange rate, contain important information in relation to the monetary policy stance. Based on this premise, a monetary policy index is estimated for Sri Lanka. The index displays that unanticipated monetary policy forms a smaller portion of monetary policy action in comparison to anticipated monetary policy. It is also observed that a decline in GDP growth is associated with anticipated policy with a short lag, while reductions in inflation are associated with both anticipated and unanticipated components of monetary policy with a longer lag of 28 to 36 months.