Abstract
This paper characterises monetary policy of Sri Lanka using policy reaction functions over the period of 1996:Q1 to 2014:Q2, where the Central Bank of Sri Lanka (CBSL) broadly followed a monetary targeting framework in the conduct of monetary policy. The standard Taylor-type and McCallum-type policy rules, augmented with response to exchange rate variations are estimated for three different specifications: contemporaneous, backward looking and forward looking. The forward looking Taylor rule and the backward-looking McCallum rule capture the monetary policy response in Sri Lanka. Results suggest that more than one-for-one reaction of the nominal interest rate in response to changes in inflation in the forward-looking Taylor specification is desirable as it leads to curtail inflation effectively, assuring determinacy. The coefficient of the output gap is, however, estimated to be larger than that of inflation. It is further evident that the CBSL responds to exchange rate variations only weakly while smoothing out interest rate strongly. A backward-looking McCallum rule where growth rate of monetary aggregate M1 (i.e. narrow money) reacts to growth rate of nominal GDP also seems to characterise monetary policy reaction in Sri Lanka satisfactorily. Strong policy smoothing and weak reaction to exchange rate are also evident in the McCallum rule.
Highlights
A monetary policy rule characterises the extent to which a central bank changes its policy instruments, in response to changes in inflation, output, or any other appropriate economic variables such as exchange rate
The results depict that the contemporaneous Taylor rule where Treasury bill rate (TBR) responds to inflation, output gap and exchange rate variation explains the monetary policy reaction most appropriately among the alternative rules
This paper empirically assesses the appropriateness of the Taylor rule and the McCallum rule in characterising the monetary policy conduct behaviour in Sri Lanka
Summary
A monetary policy rule characterises the extent to which a central bank changes its policy instruments, in response to changes in inflation, output, or any other appropriate economic variables such as exchange rate. McCallum (1988), on the contrary, introduces a policy rule where the base money growth rate responds to changes in the nominal GDP growth rate This rule is tested to be more suitable for some economies and Stark and Croushore (1998), for instance, argue that the McCallum rule leads to lower inflation than there has been over the last 30 years, in the US economy. Both rules, Taylor and McCallum, are simple and transparent in nature and aimed at delivering improved macroeconomic performance, smoothing out unexpected fluctuations of few key macroeconomic variables around their targeted paths. The rest of the paper is structured as follows: Section 2 reviews literature and provides a brief overview of the monetary policy framework in Sri Lanka; Section 3 discusses the methodology; Section 4 describes the data and provides empirical results, and Section 5 concludes
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