Demand for money in Sri Lanka during the post-1977 period: a cointegration and error correction analysis

Abstract

This paper investigates the long-run demand for money and short-run dynamics of the long-run money demand function for Sri Lanka during the post-1977 period. While M1 is cointegrated with real income, nominal interest rate, short-term foreign interest rate, and real effective exchange rate, M2 is not. This suggests that monetary authorities should emphasize the narrow definition of money for monetary control. The one year fixed deposits rate is cointegrated with M1, indicating the opportunity cost of holding money. Although the inflation rate is not cointegrated with M1, it seems to be an important determinant of the demand for M1 in the short-run. Results also suggest that the short-term foreign interest rate and the exchange rate can have important implications for the effectiveness of monetary policy. Monetary authorities must consider the response of domestic money demand to these external factors when formulating future monetary policies.