An econometric analysis of Sri Lankan monetary policy shocks and exchange rates

A growing empirical literature has sought to determine the effects of monetary policy shocks on exchange rates and other important macroeconomic variables. This paper seeks to add to this literature in the area of emerging markets by using the Vector Auto-Regression (VAR) methodology in an attempt to examine the impacts of monetary policy changes on the exchange rate for Sri Lanka over the period 1950 to 2004. Following Kalyvitis and Michaelides (2001), we employ a five-variable VAR approach that encompasses an output measure, a price indicator, a monetary policy measure, an interest rate yardstick and the exchange rate. Using impulse response functions and analysis of variance decompositions, we find that the Sri Lankan exchange rate follows the pattern suggested by the standard exchange rate model with delayed overshooting. This study further suggests that standard monetary policy is not adequate by itself for controlling the Sri Lankan economy.