Chapter 12: Currency Depreciation as a Determinant of Inflation in Sri Lanka

Purpose: This chapter uses the annual time series data to investigate how currency depreciation impacts inflation in Sri Lanka.

Design/methodology/approach: We utilized the autoregressive distributed lag (ARDL) test to evaluate the long-term correlation between the variables. Additionally, the Granger causality test was used to examine the short-term relationships.

Findings: The ARDL test findings indicate an elevated relationship between currency depreciation and long-term inflation in Sri Lanka. The coefficient value of the error correction term indicates that 1.19% of the discrepancy error is rectified each year, directing the inflation response variable toward the long-term equilibrium.

Policy Implication: The Central Bank of Sri Lanka (CBSL) should adopt a policy to tighten and lessen currency pressure and fend off inflationary pressure. To design appropriate policies, they must quantify the country’s exchange rate (ER) pass-through to inflation. The pass-through to inflation is most prominent when monetary policy action triggers or amplifies currency movements. However, this pass-through to inflation can be kept smaller provided central banks follow a credible inflation-targeting framework, operate in a flexible ER period, and are accessible from influences from fiscal authorities in the country.

Originality/value: This study uses the recently established ARDL limits cointegration approaches to investigate the enduring association between currency devaluation and price stability in Sri Lanka.