Inflation Management in Sri Lanka Essay Example for Free

Inflation Management in Sri Lanka Essay Amarasekara (2008, p. 37) also concluded that in most sub-samples, inflation does not decline following a contractionary policy shock, possibly due to the longer lag effect. Innovations to money growth raise the interest rate, and when inflation does respond, it reacts to monetary innovations faster than GDP growth does. International Monetary Fund (2008) showed that changes in policy interest rates have significant effects on output but a small impact on inflation. Credit does not respond strongly to changes in policy interest rates. 3. Objectives of the Study The Central bank conducts monetary policy to achieve its one of primary objectives of price stability by changing interest rate and money supply. Therefore, the main objective of the study is to identify the relationship between the interest rate and inflation in Sri Lanka. A successful monetary policy strategy requires an understanding of the relationship between operating instruments of monetary policy (i. e. interest rate) and the ultimate goals like the price stability and output. Therefore, the study will help to identify the effectiveness of policy rates as a monetary policy instrument for inflation management. . Model, Methodology and Data Analysis Model and Methodology A regression model will be used to estimate the effect of key variables on inflation. The main concern of the study is the effect of the interest rate on the inflation. However, the model will be incomplete without including the variables below. This study tries to improve past models done by Sri Lankan economists by including additional macroeconomic variables namely; unemployment (UN), budget deficit (BD) and foreign inflation (FI) to remove any omitt ed variables bias. In this analysis, MMR is used as changes in policy rate are immediately transmitted to MMR. Inflation: According to previous literature, past inflation has an effect on current inflation through expectations. Here the Colombo Consumer Price Index (CCPI) is used. Exchange rate (ER): Changes in in the exchange rate affects the price of exports and imports in the country, and thus has a direct effect on inflation as Sri Lanka is heavily depend on international trade. GDP growth (GDP): The GDP is seasonally adjusted to capture seasonality. Unemployment (UN): According to the Phillips Curve there is an inverse relationship between unemployment and inflation. Foreign Inflation (FI): In 2011, imports accounted for 37. 6% of GDP (CBSL Annual Report 2011) in Sri Lanka, and therefore prices of goods and services of Sri Lanka’s major trading partners can have an influential effect on inflation. Budget Deficit (BD): Most of the past literatures in Sri Lanka have omitted this important variable. However, public finance is an important issue in Sri Lanka and the effect of Monetary Policy cannot be studied without it. Data Collection For this study quarterly data will be obtained for all the variables from the first quarter of 1996 to the last quarter of 2011. The main data sources of the analysis are Annual Reports of CBSL, Monthly Bulletins of CBSL, other publications of CBSL, Annual Reports and Quarterly Reports of the Department of Census and Statistics of Sri Lanka, and the World Bank Report 2011-2012. Analytical Tools The OLS regression model will describe the significance of key variables of the model and the effectiveness of the model in explaining the objective of the study. Apart from the simple OLS regression analysis, various econometric models will be used to obtain outcomes such as unit-root tests, Granger causality tests, impulse response and AR-root tests and Vector auto regression. The Ramsey’s Reset Test will be used for checking functional form mis-specification of the model. The normality of errors and other non-spherical disturbances will be checked using White’s Test (for Heteroskedasticity) and Durbin Watson Test (for serial correlation). The model also will be tested by omitting the interest rate variable and regressing the restricted model using J-Test to determine if the model is very different.