About Monetary Policy

Overview

Monetary policy is the process by which a Central Bank manages the supply and the cost of money in an economy mainly with a view to achieve the macroeconomic objective of price stability.

Central Bank of Sri Lanka is responsible for conducting monetary policy in Sri Lanka, which mainly involves setting the policy interest rates and managing the liquidity in the economy. The monetary operations of the Central Bank influences interest rates in the economy, affecting the behavior of borrowers and lenders, economic activity and ultimately the rate of inflation. Therefore, the Central Bank uses monetary policy to control inflation and keep it within a desired path.

Economic and Price Stability

Economic and price stability is a situation where there are no wide fluctuations in the general price level in the economy, which helps to achieve sustainable economic growth. When the prices fluctuate at a low rate, they would not have any significant influence on economic decisions of agents of the economy, viz. households and firms. Moreover, price stability helps better anchor inflation expectations among public, which in turn makes it easier to keep actual inflation at low and stable levels. Therefore, stable prices would not distort the economic decisions regarding what to produce and how to produce, thus enabling efficient allocation of resources in the economy leading to economic stability and sustainable growth in the economy over the longer term.

Monetary Policy Framework

At present, the Central Bank conducts monetary policy in line with a flexible inflation targeting (FIT) framework, aimed at stabilising inflation at mid single digit levels over the medium term while supporting economic growth to reach its potential. In terms of operational aspects of this framework, the Central Bank uses its policy instruments to guide short term interest rates, particularly the average weighted call money rate (AWCMR) as the operating target.

Prior to this transition, the Central Bank conducted monetary policy within an enhanced monetary policy framework with features of both monetary targeting and flexible inflation targeting (FIT). Under this enhanced monetary policy framework, the Central Bank attempted to stabilise inflation in mid-single digits over the medium term, while supporting the growth momentum of the economy and flexibility in exchange rate management. Similar to the current practice, the AWCMR was used as the operating target.

During the early 1980s, the Central Bank adopted monetary targeting as its monetary policy framework, and monetary aggregates became the key nominal anchor in the conduct of monetary policy. Under a monetary targeting framework, the changes in money supply are considered as primary causal factors affecting price stability. In general, two major definitions of monetary aggregates are considered 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 credit and deposits. The second 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. However, given the rising volatility in money multiplier and velocity amid a weakening relationship between money supply and inflation, the role of monetary targets as a nominal anchor became uncertain and also complicated the Central Bank’s communication strategy, causing the Central Bank to upgrade its monetary policy framework.

The Central Bank conducts its Open Market Operations (OMO) within the corridor of interest rates formed by its policy rates i.e. the standing deposit facility rate (formerly the repurchase rate) and the standing lending facility rate (formerly the reverse repurchase rate), to achieve the intended inflation path. Policy rates are periodically reviewed and adjusted appropriately, if necessary, to guide the interest rate structure of the economy with a view to achieve the desired path of inflation.

FAQ on Monetary Policy