Impact of Oil Price Shocks on the Sri Lankan Economy: A Vector Auto Regression Assessment

Oil price shocks have the potential to slow down the economic growth and create inflationary pressures in oil importing small economies. A vector auto regression (VAR) model, augmented by Toda and Yamamoto procedure, was estimated using monthly data from 2000-2013 to examine the impacts of oil price shocks on Sri Lankan economy. The results indicate that linear oil price shocks affect GDP, foreign reserves and interest rate. Positive oil price shocks affect foreign reserves and the interest rate, while negative oil price shocks affect GDP, interest rates and exports. Oil price decreases have larger and quicker impacts on GDP. Thus, there is evidence for presence of asymmetric oil price impacts in Sri Lankan economy. No evidence to show that oil price shocks cause inflation. As such, the government has the ability to employ expansionary monetary policy to avoid stagflation during high oil price periods. Overall, the results indicate that the economy has a certain degree of insulation from international oil price increases. In addition, energy policy has also contributed to insulate the economy from oil price shocks through reduction in energy intensity.