AN EXAMINATION OF STABILITY OF DEMAND FOR MONEY IN SRI LANKA: IMPLICATIONS FOR MONETARY POLICY

This paper explores stability of demand function of real Broad money (M2b) in Sri Lanka using real GDP, Consumer Price Index (CPI), interest rates expressed by Savings rate and Treasury bill rate for the period 1992- 2008. The results from co- integration test suggest that there is a long-run co integrating relationship between real money and other economic variables. Real GDP and Savings rate are positively related to Broad money, while CPI and Treasury bill rate are negatively related. The estimated real income elasticity was the strongest determinant, followed by estimated price elasticity in the long run. The estimated interest elasticity is weak. The analysis of short-term dynamics using Vector Error Correction Model shows high speed of adjustment of disequilibrium. The short term relationship is relatively weaker and limited to certain variables with certain lag levels. Stability test using Chow test confirms stability of parameters during the sample period. Overall, Sri Lanka’s current practice of monetary targeting using Broad money as intermediate target is viable. Key words: Demand for Money, Stability, Co-integration, Error CorrectionFor full paper: fmscresearch@sjp.ac.l