Validity of the Monetary Model of the Exchange Rate: Empirical Evidence from Sri Lanka
Mrs. Sujeetha Jegajeevan is attached to the Economic Research Department of the Central Bank of Sri Lanka as a Senior Economist. She obtained her B.B.A. (Hons) degree with a first class from the University of Jaffna and an MBA with distinction from the Rajarata University of Sri Lanka. She has also obtained an M.Sc. Economics with merit from the University of Essex, UK. Currently, she is reading for a Ph.D. in Economics at Queen Mary, University of London. Her research interests are in the areas of Macroeconomic Modeling and Monetary Policy.
This paper studied the behaviour of the US dollar vis-à-vis the Sri Lankan rupee exchange rate in order to check the empirical validity of the flexible price monetary model of exchange rate. Data from January 2001 to March 2011 has been studied by employing the Johansen multivariate cointegration test and the Vector Error Correction Model (VEC) as the key techniques. A long-term cointegrating relationship between the nominal exchange rate and variables of monetary model has been found. The error correction term is quite large and significant indicating that short-term deviation from long-term equilibrium is restored within a year. However, regardless of the existence of a long-term relationship found between variables of the monetary model and exchange rate, the evidence is not strong enough to support the validity of the monetary model. This is mainly because of statistically insignificant domestic money supply and incorrect sign reported for foreign money supply. Improper evidences found on key variables of the model led to serious doubt about the ability of the flexible price monetary model in explaining exchange rate movements of US dollar – Sri Lankan rupee in the free floating exchange rate regime.
Staff Studies Vol.42(1&2) 2012; 47-74
How to Cite:
Jegajeevan, S., 2015. Validity of the Monetary Model of the Exchange Rate: Empirical Evidence from Sri Lanka. Staff Studies, 42(1), pp.47–74. DOI: http://doi.org/10.4038/ss.v42i1.4687