A Multivariate Cointegration Analysis of Inflation in Sri Lanka

Abstract

This study attempts to analyze the experience of inflation in Sri Lanka for the period 1978 to 2010 using the econometric framework of Johanson and Juselius cointegration approach, vector error correction model(VECM) and Granger causality analysis. The Annual time series data drawn from various annual reports of Central Bank of Sri Lanka were used in this study. The empirical results of the study indicate the existence of long run dynamic relationships among the variables. Vector error correction model shows that money supply growth, budget deficit, and exchange rate depreciation have significant positive effects on inflation. Evidence from Granger causality analysis suggests the existence of unidirectional causality from money supply to inflation, exchange rate to inflation and budget deficit to inflation is significant, while the causal relationship from inflation to money supply, exchange rate and budget deficit is insignificant. Hence, the results of this study emphasize the need to put in place a stable macroeconomic policy environment relating to these variables in an effort to maintain price stability, since low inflation would enhance economic growth.