Inflation Management in Sri Lanka
The Effectiveness of Monetary Policy and Inflation Management through the Interest Rate Channel in Sri Lanka
1. Introduction
Monetary policy comprises the rules and actions adopted by the central banks to achieve their objectives. In most countries the primary objective of the monetary policy is price stability. The Central Bank of Sri Lanka (CBSL) has two core objectives: (1) maintaining price and economic stability and (2) maintaining financial system stability (Central Bank of Sri Lanka 2012, ‘About the Bank’, para. 1). To attain the objective of price stability, the CBSL formulates and implements monetary policy by influencing the cost (interest rate) and the availability of money (liquidity). There are many instruments that the CBSL can use to conduct monetary policy. Statutory Reserve Requirement (SRR) and Open Market Operations (OMO) are the widely used instruments among them. Under OMO, the CBSL influences money supply and market interest rates by changing policy interest rates applicable to its transactions with commercial banks and/or by trading treasury bills and Central Bank Securities, to achieve price stability.
2. Literature Review
The monetary policy transmission mechanism is the process whereby monetary policy can affect the price level and output. All over the world many central banks conduct monetary policy in the framework of monetary targeting, where interest rate plays a major role in economy. Most of the studies have revealed that policy rate changes affect the inflation. However, some researchers have showed that changes in interest rate have significant effect on output but small impact on inflation.
Angeloni et al. (2002, p. 43) found that an unexpected rise in the short-term interest rate temporarily reduces output; prices respond more slowly, with inflation hardly moving during the first year and then falling gradually over the next few years. According to Ireland (2005, pp. 1-9), central banks systematically adjust the
1. Introduction
Monetary policy comprises the rules and actions adopted by the central banks to achieve their objectives. In most countries the primary objective of the monetary policy is price stability. The Central Bank of Sri Lanka (CBSL) has two core objectives: (1) maintaining price and economic stability and (2) maintaining financial system stability (Central Bank of Sri Lanka 2012, ‘About the Bank’, para. 1). To attain the objective of price stability, the CBSL formulates and implements monetary policy by influencing the cost (interest rate) and the availability of money (liquidity). There are many instruments that the CBSL can use to conduct monetary policy. Statutory Reserve Requirement (SRR) and Open Market Operations (OMO) are the widely used instruments among them. Under OMO, the CBSL influences money supply and market interest rates by changing policy interest rates applicable to its transactions with commercial banks and/or by trading treasury bills and Central Bank Securities, to achieve price stability.
2. Literature Review
The monetary policy transmission mechanism is the process whereby monetary policy can affect the price level and output. All over the world many central banks conduct monetary policy in the framework of monetary targeting, where interest rate plays a major role in economy. Most of the studies have revealed that policy rate changes affect the inflation. However, some researchers have showed that changes in interest rate have significant effect on output but small impact on inflation.
Angeloni et al. (2002, p. 43) found that an unexpected rise in the short-term interest rate temporarily reduces output; prices respond more slowly, with inflation hardly moving during the first year and then falling gradually over the next few years. According to Ireland (2005, pp. 1-9), central banks systematically adjust the
References: Amarasekara, C 2005, ‘Interest Rate Pass-Through in Sri Lanka’, Staff Studies Central Bank of Sri Lanka, vol. 35, nos 1 and 2, pp. 1-29 Amarasekara, C 2008, ‘The Impact of Monetary Policy on Economic Growth and Inflation in Sri Lanka’, Staff Studies Central Bank of Sri Lanka, vol.38, nos 1 and 2, pp. 2-38 Angeloni, I, Anil, K, Benoit, M & Daniele, T 2002, ‘Monetary Transmission in the Euro Area: Where Do We Stand?’, ECB Working Paper, no. 114 Central Bank of Sri Lanka 2012, About the Bank, Central Bank of Sri Lanka, viewed 25 August 2012, http://www.cbsl.gov.lk/htm/english/03_about/a_4.html Central Bank of Sri Lanka 2011, Annual Report, CBSL, Colombo International Monetary Fund 2004, Sri Lanka: Selected Issues and Statistical Appendix, IMF Country Report, no 04/69 Ireland PN 2005, ‘The Monetary Transmission Mechanism’, Working Papers Federal Reserve Bank of Boston, no. 06/1, pp. 1-9 Mohan, R 2008, ‘Monetary Policy Transmission Mechanism in India’, BIS Papers, no. 35, pp. 259-284 Thenuwara, HN 1998, ‘The Scope for Inflation Targeting in Sri Lanka – A Focus on the Transmission Mechanism’, Staff Studies Central Bank of Sri Lanka, vol. 27-28, pp. 1-52