Exogenous shocks and macroeconomic policies in LDCs: A study of Sri Lanka with an econometric model

Abstract

The main objectives of this paper are to analyze the impact of exogenous shocks on an economy with a strong primary commodity producing sector and underdeveloped financial and capital markets, and to present some of the macroeconomic policies that might be employed to stabilize the domestic economy in response to exogenous shocks, using an econometric model of Sri Lanka. An analysis of the impact of export price shocks on the Sri Lankan economy reveals that the sectorial adjustment mechanism and the impact on the economy are different in response to changes in the international price of each sector. However, in all cases the impact of external shocks is strongly felt in the monetary sector and the external sector. An analysis of active policies under different types of external price shocks indicates that the possibility of effective use of macroeconomic policies to offset the detrimental impact of external price shocks is constrained by the lack of independence of monetary policy, by the embryonic nature of the capital and financial markets and by limited access to foreign finance.