An analysis on monetary aggregate that reflects macroeconomic framework of sri lanka

Abstract

This thesis investigates the monetary aggregate that reflects the macroeconomic condition of Sri Lanka, the long run money demand relationship, and the determinants of money demand in Sri Lanka since 1978. The estimation ofmoney demand functions for narrow money (Ml) and broad money (M2) using quarterly data for 1978 Quarter 1 to 2009 Quarter 4 forms the basis ofthis investigation. Econometric techniques such as unit root tests, Vector autoregression (VAR) models, Cointegration relationships and some economic fundamentals like elasticities were used to achieve the objectives ofthis study. Set ofVAR models are formed and they suggest that M2 growth is best explained by the macro economic variables; Gross Domestic Product (GDP) growth, Colombo Consumer Price Index (CCPI) growth, Real Exchange rate index (REX) growth, and growths of savings and fixed deposit rates ofNational Savings Bank (NSB). This finding is further strengthened by the results of cointegration analysis as only M2 is cointegrated with its determinants. M2 growth is forecasted, to assist policy makers to have a control of monetary expansion. Only M2 had meaningful cointegrating relationships with its determinants ofGDP, CCPI, REX, and One year Fixed deposit rates of National Savings Bank and Commercial Banks. This indicates that M2 demand is stable while Ml demand is not. Therefore, in formulating monetary policy in Sri Lanka, M2 is the aggregate that need to be considered as it better reflects the macroeconomic condition. Results also suggest that, there exist high Income and Price elasticities where as low elasticities for interest rates.