Time-varying impact of monetary policy on the macroeconomy in Sri Lanka

Abstract

This study examines the time-varying effects of monetary policy on Sri Lanka's macroeconomy, focusing on price- and quantity-based instruments and transmission through market interest rate and exchange rate channels. The analysis employs three time-varying parameter vector autoregression (TVP-VAR) models with stochastic volatility using monthly data from January 2006 to March 2023. The average weighted call money rate, reserve money and broad money serve as monetary policy indicators. Impulse responses are evaluated across three horizons and at selected policy-relevant dates. The results show that monetary policy effects vary over time and are concentrated mainly in the short term. Interest rate shocks are transmitted effectively to market rates but depress stock prices and output while producing a price puzzle after 2009; thus, interest rate hikes alone cannot curb inflation. Money supply shocks operate mainly through the exchange rate channel. Their effects on stock prices are generally insignificant, and their positive effects on output are short-lived. In recent years, monetary expansion has generated stronger inflationary pressure. Similar responses at the start of interest rate hikes, the inflation peak and the end of the sample also cast doubt on the effectiveness of postpandemic monetary tightening. This study provides the first systematic evidence on the time-varying macroeconomic effects of monetary policy in Sri Lanka. By comparing price- and quantity-based instruments across different horizons and key dates, it extends the existing constant-parameter evidence and offers policy-relevant insights for Sri Lanka and other vulnerable small open economies.