This paper examines the dynamics of inflation in Sri Lanka using the cointegration approach on quarterly time series data. Considering recent empirical studies in the context of inflation in emerging countries including Sri Lanka, an empirical model has been constructed with seven variables; namely inflation, economic growth, government expenditure, exchange rate, money supply, oil prices and interest rates.
The main determinants of inflation in Sri Lanka are the economic growth, exchange rate, government expenditure, money supply, oil prices and interest rates in the long run. According to the estimated impulse response functions, both domestic shocks (money supply, interest rate and economic growth) and external shocks (exchange rate and oil prices) have an effect on inflation in the short run. These findings would be useful for policy makers in their effort in maintaining price stability in Sri Lanka on a sustainable basis.