The monetary transmission mechanism in Sri Lanka 1977-1985. A macro simulation approach to the modelling of the money supply process and the construction of an analytical framework for monetary management.

Abstract

The primary objective of this thesis is to analyse the relationship between money and the macro-economy in Sri Lanka between 1977 and 1985, in order to identify the paths through which monetary policy impulses are transmitted over this period. In doing so, - we also hope to highlight the use of macro-simulation as a tool for the analysis of the monetary transmission mechanism and to emphasise the importance of formulating monetary policy within an explicit monetary control framework. This is especially important in Sri Lanka since monetary policy has been a key instrument of demand management since 1977 and historically there has been a noticeable absence of an explicit monetary control framework. Empirical research on the monetary transmission mechanism has been very limited as far as developing countries are concerned. An exception here is the SEACEN (1981) study which simulates the effects of monetary shocks on a number of South East Asian countries, including Sri Lanka, using a flexible monetarist approach. Our research is based upon a revision of the specification of this model for Sri Lanka and a more comprehensive disaggregation of the monetary transmission channels. Our empirical model produces statistical results which are generally acceptable and conform to a Priori expectations. This model is then simulated dynamically, both, to validate the equations in the context of a complete model and to quantify the impact of alternative policy scenarios relating to the monetary transmission mechanism in Sri Lanka. We believe that our results will help to shed light on the nature of the monetary transmission mechanism in developing countries as well as provide the basis for an on-going analysis of monetary management in Sri Lanka.