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Pass through Effect of Exchange Rate and Monetary Policy in Sri Lanka

Keywords: impulse response function , Monetary policy , pass through effect , exchange rate , inflation

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Abstract:

This study examined the effectiveness of monetary policy in targeting exchange rate shock between different periods in Sri Lanka. After the trade liberalization in 1977, Sri Lanka became a small open economy. Therefore, monetary policy targeting the exchange rate also became an important issue. Sri Lanka introduced floating exchange rate system in 1990. A Vector Error Correction model and impulse response function were estimated to examine the effectiveness of monetary policy in targeting exchange rate shock for whole period from 1977 to 2007 and also separately for the periods from 1977 to 1990 and from 1990 to 2007. The results show that monetary policy is targeting exchange rate much for recent period but not targeting inflation. Inflation rate was high in the recent period. Central bank was purchasing bonds issued by the government to monetize defense spending and to increase the salaries of government employees in this period for political purpose, hence, leading to inflation and monetary policy distortion. Economic growth may be declined in long term if monetary policy is not operating optimally on targeting inflation and exchange rate.

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