Here is a brief overview of monetary policy in Sri Lanka.
One of the core objectives of the Central Bank of Sri Lanka is economic and price stability. The Central Bank formulates and implements its monetary policy, i.e. actions to influence cost and availability of money, to attain this objective.
The changes in money supply are a primary causal factor affecting price stability. In general, three definitions of monetary aggregates are used in analyzing monetary developments in Sri Lanka. The first is 'reserve money' consisting of currency issued by the Central Bank and commercial banks' deposits with the Central Bank. This is also called base money or high-powered money, as commercial banks can create deposits based on reserve money which are components of a broader definition of money supply, through their process of creating credits and deposits.
The second is narrow money, defined as the sum of currency held by the public and demand deposits held by the public with commercial banks. The third is broad money defined as the sum of currency held by the public and all deposits held by the public with commercial banks. Studies have shown that the most appropriate monetary variable to analyse the relationship between the money supply and the general price level is the broad money supply.
Monetary Policy Framework
At present, monetary management in Sri Lanka is based on a monetary targeting framework. In this framework, the final target, price stability, is to be achieved by influencing changes in broad money supply which is linked to reserve money through a multiplier. Reserve money is the operating target of monetary policy. The monetary targeting framework is operated through a monetary programme.
The monetary programme is prepared by the Central Bank taking into account economic factors such as the expected fiscal and balance of payments developments, economic growth, desired levels of growth in credit and inflation. Based on these factors, the monetary programme sets out the desired path for monetary growth and determines the path of quarterly reserve money targets necessary to achieve this monetary growth. The Bank would then conduct its Open Market Operations (OMO) within a corridor of interest rates formed by its policy rates i.e. the repurchase rate and the reverse repurchase rate, to achieve the reserve money target. Policy rates are periodically reviewed and adjusted appropriately, if necessary, to bring the reserve money to the targeted path.
At present, the Central Bank conducts its monetary policy under a system of active Open Market Operations. The key elements of the system are (i) an interest rate corridor formed by the main policy rates of the Bank i.e. the repurchase rate and the reverse repurchase rate, (ii) a daily auction either to absorb or inject liquidity, (iii) a standing facility at interest rates at the bounds of the corridor and (iv) outright transactions.
The main instruments to achieve the path of the reserve money targets are the repurchase rate and the reverse repurchase rate of the Central Bank which form the lower and upper bounds for the comparable overnight interest rates in money markets. These rates, which are the Bank's signalling mechanism on its monetary policy stance, are reviewed on a regular basis, usually once a month, and revised if necessary.
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