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Finding and Analysis
In favor on monetary targeting
Economic and price stability is a situation where there are no wide fluctuations in the general price
level in an economy which helps to achieve sustainable economic growth. In an open economy,
foreign shocks may be passed into the domestic economy. Since, the independence in 1948, the
main goal of Sri Lankan monetary policy is smoothing inflation. After the trade liberalization in
1977, Sri Lanka became a small open economy. Therefore, monetary policy targeting the exchange
rate became an important issue. Sri Lanka introduced floating exchange rate system in 1990. Since,
1977, Sri Lanka is importing more than its export. Its negative trade balance is increasing over the
years. This depreciates the Sri Lankan currency. Because government expenditure also is
increasing over the years due to defense expenditure and other investments, government budget
deficit is increasing. In order to finance government expenditure, the government treasury is using
open market operation to borrow money. This increases the money supply and then depreciates
Sri Lankan currency. Sri Lankan economy is facing higher inflation due to not only increase in
money supply but also high pass through of foreign exchange rate shock into the economy.
At present, monetary management in Sri Lanka is based on a monetary targeting framework. In
this framework, the final target is price stability. Reserve money is the operating target of monetary
policy. The monetary targeting framework is operated through a monetary programme.
With the amendments that were introduced to the Monetary Law Act No 58 of 1949, in December
2002, the objectives of the CBSL were changed to,
Economic and Price Stability, and
Financial System Stability
Monetary Policy focus on Economic and Price Stability of a country. The Central Bank formulates
and implements its monetary policy, i.e. actions to influence cost and availability of money, to
attain this objective. The Monetary Law Act (MLA), the legislation under which the Central Bank
has been established and operates, has provided a wide range of instruments for monetary
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management. At present, the monetary policy framework of the country places greater reliance on
market based policy instruments and the use of market forces to achieve the desired objectives
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.
Money Supply
Government expenditure is increasing over the years due to expenditure and other investments,
government budget deficit is increasing. In order to finance government expenditure, the
government treasury is using open market operation to borrow money. This increases the money
supply and then depreciates Sri Lankan currency.
In Sri Lanka, the Central Bank of Sri Lanka (CBSL) is the primary source of money supply. The
CBSL has a stock of minted coins and printed currency notes in its vaults to be issued as money.
However, they do not become money as long as they do not become assets of the public.
There are two channels of releasing money from the CBSL to the economy. One is acquiring
domestic assets by the CBSL through lending to the government and/or commercial banks. When
the government spends more than its revenue, its budget runs into a deficit, which has to be
financed through borrowing.
The government can borrow from many sources, including the CBSL. Borrowing from the CBSL
activates the outflow of currency notes and coins from CBSL vaults. Once the government uses
them for payments with respect to its expenses, they become assets of the general public and the
banking system. The other channel is the CBSL transactions in the foreign exchange market. When
the CBSL purchases foreign exchange from the government or commercial banks it pays in rupee
currency notes and coins expanding money supply. This graph shows how money supply has
changed since 1977
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Composition of Monetary Aggregates in Sri Lanka
The changes in money supply are a primary causal factor affecting price stability. In general, three
definitions of monetary aggregates are used in analysing 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
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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 Aggregate Targeting consider the possible responses to AD and AS shocks under
monetary aggregate targeting in which some typically quite broad monetary aggregate (M1, M2,
M3 etc.) is used as an intermediate target for monetary policy. Its note that a “Good’ Intermediate
monetary target should (1) Bear a reasonably close relationship to the short-run operating target
(e.g. a short-term policy interest rate or the monetary base); and (2) Bear a fairly close relationship
with the final target (e.g. inflation)
Monetary Policy Instruments Used to Get Monetary Targets
1. Open market operations:
2. Reserve requirements on commercial bank deposits:
3. Credit operations with banking institutions:
4. Quantitative restrictions on credit:
(a) Impose maximum maturity for commercial bank loans and advances
(b) Limit or prohibit rate of expansion of new loans and advances.
(c) Fix minimum values for the ratios of capital and surpluses to assets.
(d) Impose minimum deposit margins for letters of credit.
5. Interest rates:
(a) Determine interest rates at which CBSL provides various types of credit to banks and other
financial institutions.
(b) Fix the maximum interest rates that banks can pay on their deposits or charge for their
loans.
6. Operations in foreign exchange, i.e., external reserve management, changes in the exchange rate
and exchange control regulations.
7. Moral Suasion
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Advantages
Flexible, transparent, accountable
Almost immediate signals
fix inflation expectations - less inflation
Almost immediate accountability
Disadvantages
Need strong and stable relationship between targeted monetary aggregate & goal variable
Can you control the targeted aggregate?
Financial innovations: NEW accounts, swaps
Reserve requirement lags: complicates SRR management

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