Monetary Policy and the Real Economy: A Structural VAR Approach for Sri Lanka

This paper attempts to identify the monetary policy indicator that better explains the Sri Lankan monetary policy transmission mechanism. This study also estimates how shocks stemming from foreign monetary policy and/or oil price affect domestic macroeconomic variables. To that end, we use a seven variable structural VAR model by utilizing monthly time series data from Sri Lanka covering the period from January 1978 to December 2011. Impulse response functions and variance decompositions are used to describe the relationships among variables. Our empirical findings suggest that the interest rate shocks play a significant and better role in explaining the movement of economic variables than monetary aggregate shocks or exchange rate shocks. Second, the targeting of reserve money is a better strategy for the Sri Lankan economy than a focus on narrow or broad money. Third, our findings clearly show that foreign monetary policy shocks and oil price shocks do not seem to affect the domestic economy. Finally, the inclusion of oil price in the SVAR model helped us overcome the puzzles that often appear in the existing literature in monetary economics.