Essays on External Shocks and Monetary Policy in the Sri Lankan Economy
Date
2016
Authors
Senadheera Pathirannehelage, Yashodha Warunie Senadheera
Journal Title
Journal ISSN
Volume Title
Publisher
Abstract
The past few decades have been marked with episodes of global
economic turbulence that have created macroeconomic instability
in both developed and developing economies. With its gradual
economic integration with global markets, Sri Lanka is
increasingly exposed to unanticipated shocks emanating from
foreign economies. This dissertation, comprising of three
independent essays, aims to deepen the knowledge on the effects
of external shocks, their cross-border transmission channels and
appropriate monetary policy responses for the Sri Lankan
economy.
External shocks transmitted through trade and financial market
linkages have a considerable welfare effect on small open
economies such as Sri Lanka. The monetary policy regime of a
country plays a vital role in minimizing the social welfare
losses arising from external shocks. The first essay of this
thesis (Chapter 2) investigates the welfare implications of six
alternative monetary policy rules for the Sri Lankan economy
using a calibrated DSGE model with nominal rigidities, delayed
exchange rate pass-through and financial frictions. The model is
solved numerically by taking second-order approximation of the
full set of model equations. Domestic goods inflation targeting
rule minimizes the welfare losses caused by foreign interest rate
and foreign output shocks. Social welfare is lowest under the
strict exchange rate targeting rule when the economy is affected
by external shocks. This essay demonstrates the importance of
taking second-order approximations of the full set of model
equations in welfare analysis.
The second essay of this dissertation (Chapter 3) empirically
investigates the effects of external shocks on the Sri Lankan
economy using a Structural Vector Auto-Regression (SVAR) model
with a block exogeneity assumption and long-run and short-run
restrictions. This essay examines the impact of foreign monetary
policy shocks on the domestic economy using alternative measures:
the effective federal funds rate and the US shadow short rate.
Although domestic shocks are the primary source of macroeconomic
fluctuations in Sri Lanka, foreign shocks also play a
considerable role in explaining the variability in output growth
and domestic inflation. Shocks to foreign output growth and oil
price inflation have a notable effect on the growth of domestic
output. Shocks to the effective federal funds rate explain the
variance of Sri Lanka’s output growth better than the shocks to
the US shadow short rate. Further, the impacts of oil price
inflation and the effective federal funds rate shocks on domestic
inflation are noteworthy. The foreign shocks are transmitted to
the domestic economy through the trade channel as well as through
the financial market channel.
The deteriorating terms of trade in the past two decades has been
a concern for the policy-makers of Sri Lanka. The recent
literature has argued that the effect of the terms of trade
shocks on an economy depends on the characteristics of the
underlying shock. Using a sign restricted VAR model, the third
essay (Chapter 4) examines the effect on the Sri Lankan economy
of external shocks that cause terms of trade fluctuations. Three
external shocks, viz., world demand shocks, world supply shocks
and globalization shocks are considered in this study. The world
demand shocks do not have a significant long-term effect on Sri
Lanka’s real output, but the negative world supply shocks are
contractionary. Conversely, positive globalization shocks
increase domestic output permanently. Both positive world demand
shocks and globalization shocks are inflationary while negative
world supply shocks increase domestic prices initially but reduce
the prices after two quarters. World demand shocks have largely
contributed to the fluctuations in trade balance in Sri Lanka
since 2007, whereas the importance of globalization shocks on the
imports, exports and trade balance has increased since 2010.
Contribution from globalization shocks to the variance in
domestic output and price levels has increased since 2007.
Description
Keywords
External Shocks, Monetary Policy, SVAR model, Sri Lanka, Sign Restrictions, DSGE model
Citation
Collections
Source
Type
Thesis (PhD)
Book Title
Entity type
Access Statement
License Rights
Restricted until
Downloads
File
Description