Abstract:
The purpose of this study is to examine the nexus between money
supply and inflation in Sri Lanka over the period 1978 to 2010. The annual
time series secondary data on inflation, money supply, budget deficit and
exchange rate were drawn from various annual reports of Central Bank of Sri
Lanka. Moreover, Johanson and Juseliues multivariate cointegration test and
Granger causality tests are employed to estimate the long run equilibrium
relationship among the variables. The Augmented Dickey Fuller (ADF) unit
root test was used to examine the properties of the time series variables and
to determine the order of integration for each series in this study. The choice
of the lag length of the time series variables are based on the minimum
Akaike Information Criterion (AIC). According to the Johansen Maximum
likelihood test, the computed trace statistic, maximum Eigen statistic and
their corresponding critical statistic indicates that the null hypothesis of “no
cointegration” can be rejected at five percent level of significance. This result
supports the presence of long run relationship among the variables.
Moreover, the Granger causality test indicates while there was a significant
causality from money supply to inflation and exchange rate to inflation while
the causality from budget deficit to inflation was insignificant. Further,
analysis indicates that inflation is mainly attributed to the monetary
expansion in Sri Lanka during the post liberalization period. Therefore, this
study concludes that money supply variable can be used as an effective policy
instrument to maintain the price stability in Sri Lanka.
