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| International Monetary Fund - April 2011 Toward Inflation Targeting in Sri Lanka Rahul Anand, Ding Ding, and Shanaka J. Peiris Abstract  This paper develops a practical model-based forecasting and policy analysis system (FPAS) to support a transition to an inflation forecast targeting regime in Sri Lanka. The FPAS model provides a relatively good forecast for inflation and a framework to evaluate policy trade-offs.
The model simulations suggest that an open-economy inflation targeting rule can reduce macroeconomic volatility and anchor inflationary expectations given the size and type of shocks faced by the economy. Sri Lanka could aim to target a broad inflation range initially due to its susceptibility supply-side shocks while enhancing exchange rate flexibility and strengthening the effectiveness of monetary policy in the transition to an inflation forecast targeting regime. JEL Classification Numbers: E31, E47, E52 Keywords: Inflation Targeting, Monetary Policy, Bayesian Estimation Authors’ E-mail Adress: ranand@imf.org; dding@imf.org; speiris@imf.org This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. | Contents | | | I. Introduction | | | II. A FPAS Model for Sri Lanka | | | A. Bayesian Estimation | | | B. Estimation and Results | | | C. Forecasting | | | D. Optimal Rules | | | III. Transition to Inflation Targeting | | | A. The Role of the Exchange Rate in IFT | | | IV. Conclusions and Policy Recommendations | | | References | | | Appendix I | |
I. INTRODUCTION  The trade-offs policymakers face in the conduct of monetary policy are determined by the structure of the shocks confronting the economy and the transmission mechanisms that link monetary policy instruments to inflation and other real variables. However, there has been limited analysis of the sources of shocks (Wimalasuriya 2007 and Duma 2008) and monetary transmission mechanism in Sri Lanka (Thenuwara 1998, Thenuwara and Jayamaha 2002), providing little guidance on the optimal implementation of monetary policy.`
Monetary management in Sri Lanka is based on a monetary targeting framework.Commercial banks in Sri Lanka are at the center of a formal financial system, and, for most part, the conduct of monetary policy focuses primarily on the supply of, and demand for, reserve money (CBSL 2010). As a result, interest rates and open market operations represent an instrument to achieve a given monetary target, although the interest rate channel has become an important mechanism of transmitting monetary impulses as interbank money markets and secondary markets for government debt have developed, as in most other emerging markets. The CBSL has also, at times, tightly managed the exchange rate, further complicating monetary management. Finally, the dominance of commercial banks and information asymmetries are likely to mean that the credit channel is a prominent part of the monetary transmission mechanism (Bernanke and Gertler 1995). It is now widely accepted that the primary role of monetary policy is to maintain price stability (IMF 2005). As such, many central banks have adopted a flexible inflation targeting strategy, using interest rates as their operational target, and with very little role for monetary aggregates in the conduct of policy (Berg and others, 2010). From a theoretical point of view, the science of monetary policy, based on a New Keynesian modeling approach, does not assign money a special role in controlling inflation (Clarida, Gali, Gertler 1999). Considering further that the relation between money and prices (and output) is often volatile and unstable, a policy message from those mainstream macro models suggests disregarding monetary aggregates altogether in the analysis of monetary policy. While the global financial crisis and “great” recession has led to a re-examination of the role of monetary policy, Cúrdia and Woodford (2009) find that in a simple new Keynesian model with time-varying credit (arising because of financial frictions) the optimal target criterion (i.e. the optimal monetary policy) remains exactly the same as in the basic New Keynesian model, that is the central bank should seek to stabilize a weighted average of inflation and output gap.  In such an environment, many view the current monetary policy setting in Sri Lanka as an interim stage in a move toward wider adoption of formal inflation-targeting practices in which inflation (more precisely, expected inflation) is the intermediate target, instead of either some monetary aggregate or the exchange rate. In fact, the CBSL’s medium-term strategy considers such a transition and the annual roadmap for monetary and financial sector policies for 2011 and beyond (CBSL 2011) takes a first step by looking beyond monetary aggregates alone and signaling a gradual shift toward targeting inflation more directly. The purpose of this paper is to develop a practical model-based forecasting and policy analysis system (FPAS) to support inflation forecast targeting (Laxton and others, 2009).
There are a plethora of studies on the preconditions of moving towards inflation targeting and appropriate sequencing (see Carare and others, 2002, and Laxton and others, 2009), therefore section II focuses on implementing a FPAS model for Sri Lanka by estimating a workhorse macroeconomic model used by many inflation targeting central banks taking into account Sri Lanka specific factors. In addition, in section III we assess CBSLs current monetary framework and degree of financial development with a view identifying ways to strengthen the effectiveness of monetary policy in the transition to a fully-fledged inflation forecast targeting (IFT) regime. II. A FPAS MODEL FOR SRI LANKA
The monetary policy analysis is conducted using a small “New Keynesian” macroeconomic model with rational expectations (Berg, Karam, and Laxton 2006b).3 In recent years, the macroeconomic literature has used dynamic stochastic general equilibrium (DSGE) models and small New Keynesian models to analyze economic behavior and to forecast future developments. The DSGE models are based on theoretical underpinnings and have been found to be very useful in analyzing the effects of structural changes in the economy, as well as the effects of longer-term developments such as persistent fiscal deficits and current account deficits. On the other hand, by virtue of their relatively simple and readily understandable structure, small New Keynesian models have been used for forecasting and policy analysis purposes in central banks and by country desks in the IMF. A number of inflation-targeting central banks have used similar models as an integral part of their FPAS (see Laxton and others 2009). The model features a small open economy including forward-looking aggregate supply and demand with microfoundations and with stylized (realistic) lags in the different monetary transmission channels. External shocks from the rest of the world are captured here by U.S. growth. Output developments in the rest of the world feed directly into the small economy as they influence foreign demand for Sri Lankan products. Changes in foreign inflation and/or interest rates affect the exchange rate and, subsequently, demand and inflation in the Sri Lanka economy. The model has four behavioral equations: an aggregate demand or IS curve that relates the level of real activity to expected and past real activity, the real interest rate, the real exchange rate, and foreign demand; a price setting or Phillips curve that relates inflation to past and expected inflation, the output gap, fuel prices, and the exchange rate; - an uncovered interest parity condition for the exchange rate, with some allowance for backward looking expectations; and
- a rule for setting the policy interest rate as a function of the output gap, expected inflation, and the exchange rate.
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