The monetary approach to the balance of payments : a case study of Sri Lanka

Abstract

This study examines the empirical validity of the monetary approach to the balance of pay men ts in Sri Lanka during the period 1958-1984. In most aspects it indicates that the monetary approach is most relevant for an analysis of recent developments in the Sri Lankan balance of payments. The central point of the monetary approach to the balance of pay men ts theory is that deficits or surpluses reflect stock disequilibrium between demand and supply in the market for money. The theory is based on the premise that there is a stable demand function for money in the economy. In addition the theory implicitly assumes that there are no structural changes in the economy, especially in the balance of payments. The empirical results show that, in general, the theory holds for the Sri Lankan economy. Further, it indicates that structural changes should be taken into consideration when t.sting the theory in Sri Lanka. With t his qualification t he theory has a great er relevance to the economy. This approach to studying Sri Lanka's balance of payments reflects two main arguments. First, it is a relatively small economy with very little control over prices in the world market. Second, monetary policies have been controlled and influenced by the Central Bank, which is responsible for influencing the external balances. Thus, Sri Lanka provides not only the conditions necessary for testing a monetary model of a small open economy, but also offers some interesting in sights into the theory and policy. This is the importance of structural changes (private remittances) which need Co be included as an explicit assumption in the model.