Monetary policy comprises the rules and actions adopted by the central banks to achieve their objectives. In most countries the primary objective of the monetary policy is price stability. The Central Bank of Sri Lanka (CBSL) has two core objectives: (1) maintaining price and economic stability and (2) maintaining financial system stability (Central Bank of Sri Lanka 2012, ‘About the Bank’, para. 1). To attain the objective of price stability, the CBSL formulates and implements monetary policy by influencing the cost (interest rate) and the availability of money (liquidity). There are many instruments that the CBSL can use to conduct monetary policy. Statutory Reserve Requirement (SRR) and Open Market Operations (OMO) are the widely used instruments among them. Under OMO, the CBSL influences money supply and market interest rates by changing policy interest rates applicable to its transactions with commercial banks and/or by trading treasury bills and Central Bank Securities, to achieve price stability.
2. Literature Review
The monetary policy transmission mechanism is the process whereby monetary policy can affect the price level and output. All over the world many central banks conduct monetary policy in the framework of monetary targeting, where interest rate plays a major role in economy. Most of the studies have revealed that policy rate changes affect the inflation. However, some researchers have showed that changes in interest rate have significant effect on output but small impact on inflation.
Angeloni et al. (2002, p. 43) found that an unexpected rise in the short-term interest rate temporarily reduces output; prices respond more slowly, with inflation hardly moving during the first year and then falling gradually over the next few years. According to Ireland (2005, pp. 1-9), central banks systematically adjust the short-term nominal interest rates in response to movements in inflation and output. Further, this analysis showed that in a low inflation environment where nominal interest rates are also low on average. Mohan (2008, pp. 259-284) examined the transmission mechanism of monetary policy in India. He summarized that monetary policy impulses impact on output and prices through interest rate and exchange rate movements in addition to the traditional monetary and credit aggregates. Further, he showed that the transmission lags are surrounded by a great deal of uncertainty.
Most of the researches carried out on the monetary policy transmission mechanism in Sri Lanka have highlighted the interest rate channel and credit channel. Thenuwara (1998, p. 47) identified that the interest rate channel is found to be the most effective channel in Sri Lanka. There is a close relationship between the central bank policy rates and call money market rates. However, he identified pass-through effects from call money market rates to other market rates virtually non-existent.
Amarasekara (2005, p. 29) concluded that, the CBSL policy decisions are efficiently transmitted to the short end of the money market within a matter of days. Further, he showed that, there is a complete pass-through from policy interest rate to call money market rate. However, the pass-through from call money market rates to commercial bank retail interest rates is sluggish and incomplete. Amarasekara (2008, p. 37) also concluded that in most sub-samples, inflation does not decline following a contractionary policy shock, possibly due to the longer lag effect. Innovations to money growth raise the interest rate, and when inflation does respond, it reacts to monetary innovations faster than GDP growth does. International Monetary Fund (2008) showed that changes in policy interest rates have significant effects on output but a small impact on inflation. Credit does not respond strongly to changes in policy interest rates....