The Impact of monetary policy on inflation and production: a comparative study on Sri Lanka, India, and the USA

Abstract

Monetary policy is a critical tool used by the Central banks to stabilize inflation and foster economic growth. Over the past few years, the Sri Lankan economy faced significant economic challenges, such as economic downturn, and rising inflation. This led the Central Bank of Sri Lanka to execute various monetary policy changes to stabilize the economy. This study examines the effects of monetary policy transmission mechanisms (MTM) on production and inflation in the USA, India, and Sri Lanka, using monthly data from 1980 to 2023, to provide a comparative understanding of how monetary policy adjustments influence each of these economies. The analysis employs the Vector Error Correction Model (VECM) to understand the short-term and long-term effects of monetary policy adjustments on Gross Domestic Production (GDP) and the Consumer Price Index (CPI). The results of this study indicate major differences in the magnitude and timing of the policy implementation and its effects across the three economies: where the USA economy indicates quicker adjustments to monetary policy changes, which reflects their advanced financial infrastructure. In contrast, India and Sri Lanka demonstrate delayed responses, suggesting inefficiencies in their policy transmission mechanisms. In addition to this, the results also indicated that in the USA, interest rates and money supply have predictive power over both CPI and GDP. This implies that policymakers can use these channels to manage inflation and economic growth. In India, none of the independent variables showed a correlation between CPI and GDP, while in Sri Lanka, domestic credit to the private sector and money supply significantly impacts GDP and CPI. These results imply that it is vital to have tailored monetary policies for each economy considering their unique structural and temporal characteristics. For the USA, the results affirm the effectiveness of its current policy framework, while India and Sri Lanka may require enhanced policy strategies to improve transmission efficiency.