Effectiveness of the Interest Rate Channel as a Mean of Monetary Transmission in Sri Lanka

Abstract

The study investigates whether interest rate make significant negative impact on investment leading economic growth. Policy makers expect to achieve the economic and price stability through effective monetary policy. Traditional interest rate channel is a major transmission channel of the monetary policy that transforms the policy shocks to the macro economy through the investment expenditure. Interest elasticity of investment should be more and negative value for sound interest rate channel to achieve monetary policy objectives. In the study, Investment on construction (CONSTR) is taken as dependent variable and fixed deposit Rate (FDR), real Income (RGDP), Colombo Consumer Index (CCPI) and Exchange Rate (ER) are taken as independent variables. The data of the period from 1978 to 2014 is used for the study. Due to the non-stationarity of selected variables, Vector Error Correction test through Co-integration methodology is applied to estimate the long-run model and the short-run dynamics of investment. The variables; interest rate (FDR) and exchange rate (ER) are negatively related with investment, and price level and income are positively related with investment in the estimated long-run model. The value of interest rate elasticity of investment is 0.06, and that is a very small value. Lower interest rates encourage investments in the country, but the influence is not in the satisfactory level. This negative coefficient of interest rate is highly significant and consistent with existing theories. Less interest sensitivity of investment proves that the usefulness of traditional interest rate channel is not in a satisfactory level to transform monetary policy shocks to maintain policy co-objectives in Sri Lanka. An expansionary monetary policy does not make an enough positive effect on output level.