Effectiveness of the Interest Rate Channel for Controlling Price Level in Relation to Sri Lanka

Abstract

The study focuses on examining the effectiveness of interest rate channel as a main monetary transmission channel to achieve price stability in Sri Lanka using the data for the period from 1977 to 2010. Vector Error Correction model was used for the analysis. According to the test results, there is a positive relationship between interest rate and price level in the long run. This estimated coefficient is significant but inconsistent. The results prove that interest rate channel in the transmission mechanism of monetary policy is not effective in the Sri Lankan context. Price level has a positive relationship with money supply and exchange rate, and a negative relationship with income in the long run. Coefficients estimated in the long run inflation model are statistically significant and consistent. According to the Vector Error Correction test, price level has a long run relationship with other related variables in the system but not short run dynamics.

Key words; interest rate channel, inflation, coefficients, co-integration test, vector error correction model