The relationship between money supply and interest rates: an empirical investigation in Sri Lanka

Abstract

Introduction:

Monetary policy in Sri Lanka, targets maintenance of monetary growth that is consistent with economic and price stability and stability in the financial system. The primary tools of policy instruments are Central Bank policy interest rates. Economic theory offers two seemingly contradictory views on money and interest rate relationship (Monnet and Weber 2001). The liquidity effect view states that money and interest rates are negatively related (Christiano et al., 1999). Money is a decreasing function of the nominal interest rate because the interest rate is the opportunity cost of holding liquidity. In the Fisher equation tradition, money and interest rates are positively related. Increasing interest rates requires an increase in the rate of money growth. The Fisher equation states that the nominal interest rate equals the real interest rate plus the expected rate of inflation. This paper mainly focuses on the liquidity effect view and the Fisher effect view.

Most empirical studies have found a relationship between money and interest rates (Monnet and Weber 2001). Nevertheless there are not many studies done previously on Sri Lanka. The available studies have not used modern econometric methods for estimation, latestdata and coverage is narrow (Wijewardena, 1985; Silva, 1977). This scenario motivates us to analyze the relationship between money supply and interest rates in Sri Lanka using current data and up to date methods.