Essays on External Shocks and Monetary Policy in the Sri Lankan Economy

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.