This paper characterises monetary policy of Sri Lanka using policy reaction functions over the period of 1996:Q1 to 2014:Q2, where the Central Bank of Sri Lanka (CBSL) broadly followed a monetary targeting framework in the conduct of monetary policy. The standard Taylor-type and McCallum-type policy rules, augmented with response to exchange rate variations are estimated for three different specifications: contemporaneous, backward looking and forward looking.
The forward looking Taylor rule and the backward-looking McCallum rule capture the monetary policy response in Sri Lanka. Results suggest that more than one-for-one reaction of the nominal interest rate in response to changes in inflation in the forward-looking Taylor specification is desirable as it leads to curtail inflation effectively, assuring determinacy. The coefficient of the output gap is, however, estimated to be larger than that of inflation. It is further evident that the CBSL responds to exchange rate variations only weakly while smoothing out interest rate strongly. A backward-looking McCallum rule where growth rate of monetary aggregate M1 (i.e. narrow money) reacts to growth rate of nominal GDP also seems to characterise monetary policy reaction in Sri Lanka satisfactorily. Strong policy smoothing and weak reaction to exchange rate are also evident in the McCallum rule.