Monetary targeting in Sri Lanka: how much control does the central bank have over the money supply?

This paper empirically addresses the questions “is money supply in Sri Lanka endogenous or exogenous and how much control does the Central Bank have over the money supply?” Thus the paper also examines the viability of the current monetary targeting policy regime. Two complementary approaches are used. The first is the monetarist approach and tests whether money supply is exogenously determined by testing the stability of the broad money multiplier and by testing for a long-run relationship between monetary base and broad money supply. The second approach tests the Post-Keynesian contention that the money supply is endogenous with the financial system as a whole causing changes to the money supply through bank lending creating monetary liabilities. The findings indicate the broad money multiplier is not stable and the tests of the endogenous money theory shed light on why it is unstable. The overall results cast doubt the effectiveness of the current monetary targeting policy regime in Sri Lanka.