J Econ Finan

DOI 10.1007/s12197-015-9350-6

Monetary targeting in Sri Lanka: how much control

does the central bank have over the money supply?

Wasanthi Thenuwara 1 & Bryan Morgan 2

# Springer Science+Business Media New York 2015

Abstract This paper empirically addresses the questions Bis money supply in Sri
Lanka endogenous or exogenous and how much control does the Central Bank have
over the money supply?^ Thus the paper also examines the viability of the current
monetary targeting policy regime. Two complementary approaches are used. The first
is the monetarist approach and tests whether money supply is exogenously determined
by testing the stability of the broad money multiplier and by testing for a long-run
relationship between monetary base and broad money supply. The second approach
tests the Post-Keynesian contention that the money supply is endogenous with the
financial system as a whole causing changes to the money supply through bank lending
creating monetary liabilities. The findings indicate the broad money multiplier is not
stable and the tests of the endogenous money theory shed light on why it is unstable.
The overall results cast doubt the effectiveness of the current monetary targeting policy
regime in Sri Lanka.

Keywords Monetary supply . Monetary targeting . Money multiplier . Endogenous

money theory

JEL Classification E510 . E520 . E580

1 Introduction

In countries where authorities use a monetary targeting approach to conduct monetary

policy, the issues of the stability of the money multiplier and whether money is
endogenous or exogenous are critical to successful policy implementation. The

* Bryan Morgan
b.morgan@uq.edu.au

1
UNE Business School, University of New England, Armidale, NSW 2351, Australia
2
School of Economics, University of Queensland, Brisbane, Qld 4072, Australia
 J Econ Finan

Central Bank of Sri Lanka (CBSL) has a long history of using a monetary targeting
framework and currently seeks to achieve its final target of price stability by controlling
the quantity of broad money (M2) in the economy. The rationale of monetary targeting
is that excess money growth will ultimately lead to inflation. Consequently, effective
monetary targeting hinges on several prerequisites: the target monetary aggregate must
be well controlled by the central bank, there must be a strong and reliable relationship
between the goal variable (inflation) and the target aggregate (money supply), there
must be a stable money demand function and the targets for the intermediate aggregate
must be announced to shape public expectations for inflation.
Such a monetary strategy thus relies on the understanding from orthodox monetary
economics that the money supply is exogenous. The orthodox (monetarist) approach
emphasizes that the monetary base (reserve money or high powered money) is a
constraint on the money supply. The conventional money multiplier models hence
argue that monetary base is exogenous since it is the monetary liability of the central
bank and broad money multiplier is stable and predictable. If this is true, then monetary
authority could control money supply as long as monetary base is kept at the desired
level in line with the targeted broad money expansion and hence the money supply is
exogenous. The monetary targeting framework then relies on the assumption that there
is a stable relationship between monetary base and money supply. The money multi-
plier links these two measures of money and it measures the changes in money supply
to a given change in the monetary base. Consequently, provided that the monetary base
is under the control of the monetary authority and the money multiplier is stable, it
follows that the money supply is exogenous.
However, there is growing body of research, mainly from the Post Keynesian
School, which asserts that money supply is endogenously determined. Seminal work
was provided by Kaldor (1980, 1982) and developed by researchers such as Moore
(1988a); Palley (1987–88, 1994) and Wray (1995). 1 Post Keynesian theories of
endogenous money emphasize that, apart from the central bank’s role in changing the
monetary base, the financial system as a whole contributes to the creation of money in
its response to the demand for credit by the public. Further, Cottrell (1994) argues that
in a modern ‘credit-money-economy’ a central bank is bound to accommodate the
private sector credit demand not as a matter of ‘political choice’ but as a matter of
‘structural necessity’.
Very little research has been carried out into whether monetary targeting is an
appropriate policy approach for Sri Lanka. While money demand studies exist for Sri
Lanka, for example Weliwita and Ekanayake (1998); and Dharmaratne (2004), the
impact of financial innovation on money multipliers and monetary aggregates has
largely been ignored. There are no recent published studies that test how much control
the CBSL has over the money supply.
This paper fills these gaps and investigates the endogeneity/exogeneity of money
supply in Sri Lanka. This research further provides an insight into the viability of the
monetary targeting framework used in Sri Lanka. To do this, we employ two different
approaches. The first is to follow the orthodox monetarist’s approach and test the
stability of the broad money multiplier. The second draws on Post Keynesian money
supply theories and tests whether broad money in Sri Lanka is endogenous.

1
Endogenous money theories are discussed in more detail in Section 2
J Econ Finan

The results do not support the monetarist (orthodox) view. Both the monetary base
and broad money are non-stationary. The two variables are integrated of order one but
they are not cointegrated. Also, the stationarity tests for broad money multiplier
confirm that broad money multiplier is not stable. However, the findings support the
Post Keynesian contention that money supply is endogenous. The tests results show
bidirectional causality between bank credit and the broad money supply and between
bank credit and the broad money multiplier and significant long-run and short-run
relationships between variables.
The remainder of the paper is structured as follows. Section 2 reviews the endog-
enous money theory and recent empirical studies that test it. Section 3 provides an
overview of monetary policy and the behaviour of monetary aggregates in Sri Lanka.
Sections 4 and 5 describe the data and empirical methodology respectively. The
empirical results will be discussed in Section 6. The final section reports conclusions
and policy implications.

2 The endogenous money theory

The modern, Post Keynesian formulation of endogenous money theory was instigated
by Nicholas Kaldor in the 1970s in opposition to monetarist theories. Subsequent
theories proposed by Kaldor (1982, 1985) and Basil Moore (1988a) emphasized that
the core element of endogenous money is the credit creation phenomenon where banks
create money as bank deposits to meet the expenditure decisions of economic agents.
Palley (1994) elaborate this further to highlight that credits are created when banks
respond to asset and liability management decisions of three main channels namely; (i)
the commercial banks, (ii) portfolio decisions of the non-bank public and (iii) demand
for bank loans.
The literature reveals three distinct views of endogenous money theory. They are the
accommodationist (Moore 1988b), the structuralist (Palley 1987–88, 1994) and the
liquidity preference (Howells 1995; Wray 1995) approaches. The common feature of
these theories is the rejection of the orthodox or monetarist theory of an exogenous
money supply in which the central bank has control over the quantity of money in the
economy by a combination of the ability to control the quantity of monetary base and a
stable money multiplier mechanism.
The accommodationist view directly challenges the orthodox monetarist approach
and recognises that commercial banks are in the business of selling credit and are price
setters and quantity takers in their retail lending and deposit taking markets. Bank
borrowers are key determinants of the loans, while central banks set interest rates and
preserve liquidity of the financial system providing currency and reserve on demand.
That is, the loan portfolio decisions are affected by the central bank’s policy rates and
the supply of reserves. Moore (1998) further states that reserves must always be
provided by the central banks on demand to ensure the liquidity of the financial system,
and fulfil their role as a lender of last resort. Accordingly, accommodationists predict a
unidirectional causality from bank credit to the monetary base.
The structuralist approach is based on different assumptions about the behaviour of
commercial banks and the central bank. In contrast to the accommodationists’ ap-
proach, the structuralist’s theories emphasize that commercial banks’ management of
 J Econ Finan

their assets and liabilities is a determinant of the money supply (Palley 1994). In this
theory the money supply curve is considered to be upward sloping but moves to
the right over time and in the long run approximates a horizontal supply curve
(Chick and Dow 2002). Commercial banks hold secondary reserves that act as
a buffer stock and allow them to offset the effects of changes to interest rates
by the central bank. The structuralist view predicts bidirectional causality
between bank credit and monetary base. Furthermore, structuralist accepts the
concept that loan creates deposits and deposits make reserves, which implies
that in addition to the feedback relation of bank credit with monetary base, it
also relates with the money multiplier.
The two theories of endogenous money outlined above focus on the central
bank’s response through the money supply function to changes in the demand
for bank loans. The third theory, the liquidity preference theory proposed by
Howells (1995), explicitly introduces the demand for credit money. Howells
(1995) argues that the central point of contention amongst endogenous money
theorists is explaining the mechanism that ensures that newly created loans are
matched by newly created deposits since they reflect different preferences held
by different groups of individuals. Howells (1995) rejects the accommodation-
ists view that there can never be an excess supply of credit money, which
implies that there is no independent demand curve for credit money. The
liquidity preference theory of endogenous money relies on the existence of an
active independent money demand function. The liquidity preference view
implies bidirectional causality between bank credit and monetary aggregates.
The three theories of an endogenous money supply in the Post Keynesian approach
share a common view that the money supply is determined from within financial
markets. While there are debates about which theory is the most appropriate, each
has as a central hypothesis that demand for loans originates within the economic system
and hence the causality runs from bank credit to the money supply.
There have been a number of empirical studies testing the endogenous
money hypothesis. A recent study by Badarudin et al. (2013) provides new
evidence on endogenous money supply theory using long time series for G-7
countries. The findings conclude that in a majority of cases money supply is
endogenous and banks respond to the credit demand by the public. On the
other hand, Panagopoulos and Spiliotis (2008) find mixed results for G-7
countries. Howells and Hussein (1998) find strong evidence for causality being
from bank lending to money supply in G7 countries and these findings were
consistent with the findings of Moore (1988b) and Palley (1994) for U.S. data.
Palley (1994) finds that the results of Granger causality tests are consistent with
the structuralist view of endogenous money.
Studies based on individual developed countries such as by Arestis (1987);
Moore (1989); Foster (1992, 1994); Hewiston (1995) and Howells (1995)
support the conclusion that money is endogenous and bank lending causes
increases to the money supply. Similar results are established for emerging
economies, for example Nell (2000) for South Africa; Vera (2001) for Spain;
and Vymyatnina (2006) for Russia. In the case of less developed countries,
Omer et al. (2008) establish the endogeneity of money for the Pakistan money
supply.
J Econ Finan

3 Monetary aggregates and monetary policy in Sri Lanka

At present the CBSL defines and publishes data on three monetary aggregates 2: the
monetary base (MB) which is currency in circulation, commercial banks’ domestic
currency deposits maintained at the central bank as required by the statutory reserve
ratio, and deposits of selected government agencies with the central bank; narrow
money (M1) which is currency and demand deposits denominated in rupees held by the
public with commercial banks; broad money (M2) which is currency and demand,
savings and time deposits denominated in rupees and foreign currency held by the
public with commercial banks.
Four distinct phases of monetary policy, based on the policy objectives, can be
identified in past 65 years in Sri Lanka (see Table 1). Two of these phases occurred
during the closed economy period from1950 to 1977 and two occurred after the
economy began to be liberalised in1977.
The CBSL outlines its current monetary policy framework as follows: BAt
present, monetary management in Sri Lanka is based on a monetary targeting
framework. In this framework, the final target, price stability, is to be achieved
by influencing changes in broad money supply which is linked to reserve
money through a multiplier.^ This policy framework relies explicitly on the
monetarist exogenous money theory.
In order to achieve monetary policy objectives, CBSL has three monetary
policy tools at its disposal namely; (i) open market operations (OMOs), (ii)
standing facilities (discount window lending) and (iii) minimum reserve require-
ments for credit institutions. These policy tools are used to adjust the supply of
bank reserves relative to the reserve demand in order to achieve and maintain
the desired level of money.
The CBSL conducts open market operations through the purchase or sale of
government securities which directly affects monetary base and bank reserves.
This affects the quantity of non-borrowed reserves though this is not identical
to total required reserves because some banks hold excess reserves while others
borrow reserves from the CBSL. The central bank provides short-term loans to
private banks through discount window lending if they do not have sufficient
deposits to meet the reserve requirements. In addition, the required reserve
requirement underlies the relationship between the volume of reserves and the
transaction deposit component of money. Required reserves are always made
available for banks on demand, but at a price.
Available information on targeted and actual values of monetary aggregates is
limited to seven years, 2001 to 2007. These data are shown in Table 2. Even
in this small sample we observe how significant deviations from the target,
mainly positive, are the norm. Also note that the year-to-year increase in the
targets and outcomes is high.
The central bank’s monetary policy objective is price stability. Fig. 1 shows
Sri Lanka’s inflation rate since 1990 as measured by the consumer price index.

2
http://www.cbsl.gov.lk/htm/english/08_stat/s_5.html
 J Econ Finan

Table 1 Major phases of monetary policy in Sri Lanka

Phase Time duration Objective dominated

Phase 1 1950–1960 Stabilization objective

Phase 2 1960–1977 Development objective
Phase 3 1977–1989 Both stabilization and
development objectives
Phase 4 After 1990 Stabilization objective

Source: Reproduced from Central Bank of Sri Lanka (1998), Economic Progress of Independent Sri
Lanka, p. 260

It can be seen that the inflation rate is not only high but also variable. The average
inflation rate from 1990 to 2013 was 10.3 % with a standard deviation of 4.7 %. Source:
International Monetary Fund, International Financial Statistics.

4 Data

The empirical analyses are conducted using quarterly data from 1990 to 2011, corre-
sponding to the phase 4 in Table 1. This period is chosen because of the structural
breaks caused by the policies of economic liberalization implemented in 1977 and
1989. These two periods of economic liberalization, particularly the latter period,
introduced radical changes in the financial system and contributed to substantial
increases in both monetary base and broad money since 1990 (see Fig. 2). Further,
during the fourth phase of monetary policy (1990 onwards), financial market develop-
ments, particularly the rapid integration with global financial markets, influenced the
manner in which monetary policy is conducted.
Data after 2011 are available but are not used because the definition of the monetary
base used in the published data (with monthly frequency) was changed in 2012 (as per
the 2012 Annual Report appendix table) and thus is inconsistent with the earlier data.

Table 2 Targeted and actual monetary aggregates in Sri Lanka

Year Monetary base (Rs. Billion) Broad money (Rs. Billion)

Target Actual Deviation Target Actual Deviation

(actual-target) (actual-target)

2001 118.6 112.5 −6.1 549.1 549.0 0.1

2002 126.1 126.4 0.3 617.8 622.5 4.7
2003 142.9 142.0 0.9 701.2 717.9 16.7
2004 163.2 171.0 7.8 814.8 858.6 43.8
2005 196.5 197.9 1.4 987.4 1022.3 34.9
2006 227.6 239.8 12.2 1175.6 1204.6 29.0
2007 267.6 264.4 −3.2 1382.5 1404.0 21.5

Source: Central Bank of Sri Lanka

J Econ Finan

25.00

20.00

15.00

%
10.00

5.00

0.00

Fig. 1 Inflation in Sri Lanka, 1990 to 2013

Note, however, that the CBSL uses the pre-2012 definition of the monetary base for
monetary policy purposes and those data are available, but only with annual frequency, in
the chapter 7 of the CBSL Annual Reports.3 The main data sources are the statistical tables
from the CBSL web site available online (http://www.cbsl.gov.lk/info/08_statistics/s_5.
htm) and the CBSL annual report publications appendix tables and special appendix
tables for various years. The key time series used in the analysis are as follows.

MB-Monetary base as defined in Section 3.

M2-Broad money as defined in Section 3.
M2M-Broad money multiplier (M2/MB).
BC-Bank credit.

In the following sections log values of these variables are indicated by upper case
letters preceded by BL^. Refer appendix for the time series.

5 Empirical methodology

We address the overall research question from two perspectives. The first is based on
the conventional money multiplier model of monetary economics, the second on the
endogenous money supply theory. The testable hypotheses, key assumptions and
econometric tests used are summarized in Table 3.
While the hypothesis H0[1] is used to examine the monetarists view, hypotheses
H0[2], H0[3] and H0[4] are used to test the three distinct views of the endogenous
money theory discussed in Section 2. The hypothesis bank credit causes the monetary
base (H0[2]) tests the accommodationist view. The nulls of bidirectional causality
between bank credit and broad money multiplier (H0[3]) and bidirectional causality
between bank credit and broad money supply (H0[4]) are used to test structuralist and
liquidity preference views respectively.
The stability of broad money multiplier (H0[1]) is tested using two approaches. In
the first approach, unit root/stationarity tests are applied to the broad money multiplier.
The second approach is based on the link between broad money and the monetary base.

3
See CBSL Annual Reports 2012 and 2013
 J Econ Finan

2500 Broad Money 1980-2011*

2000

Rs. Billion
1500

1000

500

0
1980 1985 1990 1995 2000 2005 2010

450 Monetary Base 1950-2011

400
350
Rs. Billion

300
250
200
150
100
50
0
1950 1960 1970 1980 1990 2000 2010

* Use of the current definition of broad money commenced in

1980
Fig. 2 Monetary aggregates in Sri Lanka

The broad money multiplier (M2M) is the ratio of broad money supply (M2) to the
monetary base (MB). Thus, the broad money multiplier is stable if and only if the ratio
of M2/MB is stationary.

M 2 ¼ M2M  MB ð1Þ

Taking the log transformation of Eq. (1) gives:

LM2 ¼ LM 2M þ LMB ð2Þ

where LM2 is the log of the broad money supply, LMB is the log of the monetary base and
LM2M is the log of the broad money multiplier. Therefore a necessary condition for the
stable long-run multiplier is the stationarity of LM2M. This condition can arise in two cases.

Case 1: both LM2 and LMB are stationary in Eq. (2).

Case 2: if both LM2 and LMB are non-stationary with the same order of integration,
then LM2 and LMB are cointegrated with a cointegrating parameter equal to one.

Case 1 is tested using unit root/stationarity tests while case 2 is tested by employing
a residual based cointegration test. In case 2, since our concern is to test whether both
variables have the same order of integration first, and then testing whether the
cointegration parameter equals to one, residual based cointegration test is preferred
over ARDL test even though both tests can be used for testing long-run relationships
between variables. However, in the causality tests for testing endogenous money
theory, the ARDL test is used since the order of integration does not have to be the
same and it is a superior test for causality over residual based cointegration tests.
J Econ Finan

Table 3 Summary of Empirical Methodology

Perspective Testable hypothesis Assumptions Econometric tests

Orthodox H0[1]: The broad The monetary base is (i) Unit root/stationarity
(Monetarist) money multiplier under the control of the tests Augmented Dickey
is stable monetary authority and Fuller (ADF), Phillips-
hence there is a stable Perron (PP) and
link between the monetary Kwiatkowski-Phillips-
base and broad money. Schmidt-Shin (KPSS)
test
(ii) Residual based
cointegration test
Endogenous H0[2]: Bank credit The demand for reserves is Long-run relationship
money causes the monetary fully accommodated by and causality test
base the central bank and Autoregressive Distributed
commercial banks within Lag (ARDL) bounds
a competitive banking test
market (Badarudin et al.
2013, p. 148).
H0[3]: Bidirectional There exists an active
causality between independent money
bank credit and demand function.
broad money
multiplier
H0[4]: Bidirectional
causality between
bank credit and the
broad money

5.1 Unit root/stationarity test

The ADF is the most common and popular test for unit roots. However, ADF test has
certain limitations and the PP test overcomes some of those. The two tests often give
the same conclusions and the corresponding null and alternative hypotheses are as
follows:

H0: Series has a unit root vs H1: Series is stationary.

To overcome the ambiguity of the conclusions when the root of the characteristic
equation is close to the non-stationary boundary (i.e. close to one) the KPSS stationary
test is used. The null and alternative hypotheses for the KPSS test are:

H0: Series is stationary.

H1: Series has a unit root.

Accordingly, the regression models given in Eqs. (3) and (4) are used in general to
test the unit roots/stationarity of a time series zt in levels and first differences respec-
tively. Inclusion of a constant and the time trend is determined based on a visual
inspection of the time series of interest. The appropriate asymptotic critical values are
noted for each case separately.
 J Econ Finan

In levels:
Δzt ¼ φzt1 þ ∑pi¼1 αi Δzti þ ut ð3Þ

In first differences:
0 0
Δ2 zt ¼ φ Δzt1 þ ∑pi¼1 αi Δ2 zti þ ut ð4Þ
0
where ut ~ iid(0, σ2) and p is the lag length. αi ; αi (i = 1 , ⋯ p), φ and φ' are the
coefficients to be estimated.

5.2 Residual based cointegration test

Suppose that two time series of z1t and z2t are integrated of order one (i.e. I(1)) and
consider the cointegration regression as given in Eq. (5).

z2t ¼ β0 þ β 1 z1t þ et ð5Þ

where βi (i = 0 , 1) are the coefficients to be estimated.

In order for z1t and z2t to be cointegrated, the necessary condition is that the
estimated residuals from Eq. (5) should be stationary (i.e. et ~ I(0)). The ADF test
can be used on et using the regression given by Eq. (6).

Δe^t ¼ δe^t1 þ vt ð6Þ

where vt are iid errors. However, critical values are not the same as for testing raw data
and thus Engle and Granger (1987) critical values have to be used.

5.3 ARDL modelling approach for tests for endogenous money theory

The endogenous money hypotheses in Table 1 (H0[2], H0[3] and H0[4] are tested using an
autoregressive distributed lag (ARDL) approach in two steps. In the first step we determine
whether a long-run relationship exists between the variables of interest and the direction of
causality is determined. If a long-run relationship is established, then in the second step, the
significance of the long-run coefficients and the error correction terms are estimated.
Traditionally tests of causality have involved first testing for cointegration between
variables using either the Engle-Granger approach or the Johansen technique. These
approaches suffer from two shortcomings. All of the variables included in the model
must be integrated of the same order. In addition there is low power in small samples
when testing for unit roots. The ARDL approach as developed by Pesaran and Pesaran
(1997), Pesaran and Shin (1999) and Pesaran et al. (2001), overcomes these problems.
The ARDL procedure can be applied irrespective of whether the variables are I(1)
and/or I(0) and hence it avoids the pre-testing problems associated with the standard
cointegration approach. Further, a dynamic error correction model (ECM) can be
derived from the ARDL model through a simple linear transformation. Finally, the
ARDL approach allows the optimal lag lengths for variables to differ, while the
Johansen technique requires all variables in the model to have the same number of lags.
J Econ Finan

The testable hypotheses considered in this paper contain two variables in each case.
For generality, we describe the ARDL procedure considering two hypothetical time
series xt and yt and the actual variables used will be specified in results section.

y t ¼ α 0 þ α 2 x t þ et ð7Þ

where et is the vector of error terms and α0, α1 and α2 are coefficients to be estimated.
Following Pesaran et al. (2001), the conditional ECM (ARDL) specification of Eq. (7)
is given in Eq. (8).

Δyt ¼ ρ0 þ ∑ri¼1 μ1i Δyti þ ∑si¼0 μ2i Δxti þ π0 ecmt1 þ ϵ t ð8Þ

Equation (8) can be estimated using OLS technique and r and s are the optimal lag
lengths for the ARDL model. The short-run effects are quantified by μ1i and μ2i. The
coefficient estimate of the error correction term, (π0) indicates the adjustment process to
the long-run equilibrium in the dynamic model. The coefficient should be statistically
significant and possess a negative sign. A statistically significant negative ecm coeffi-
cient also confirms the existence of a long-run relationship and it indicates evidence of
long-run causality from explanatory variable to the dependant variable. The t-test is
used to test the statistical significance of the π0 compared with the new critical values
presented in Banerjee et al. (1998).
Following the similar steps to Bahmani-Oskooee and Fariditavana (2015, p. 521),
Eq. (7) is solved for et and the solution is lagged by one period using Eq. (9) below to
obtain ecmt - 1.
ecmt1 ¼ yt  α0  α2 xt1 ð9Þ

Now replace ecmt - 1 in Eq. (8) by the right hand side of Eq. (9) to obtain the
following linear ARDL model similar to Pesaran et al. (2001).

Δyt ¼ β 0 þ ∑pi¼1 δ1i Δyti þ ∑pi¼0 δ2i Δxti þ γ 1 yt1 þ γ 2 xt1 þ εt ð10Þ

The error terms (εt) are serially uncorrelated. In Eq. (10), the causality runs from xt to
yt. Reverse causality can be tested by switching x and y in Eq. (10). The optimal lag
length of the underlying VAR is selected using model selection criteria such as
Schewartz-Bayesian (SBC) and Akaike Information Criteria (AIC). The coefficient
estimates of δ1i and δ2i (for i = 1 , … p) represent the short-run dynamics and γi (for
i = 1 , 2) represent the long-run multipliers of the underlying ARDL model. However,
the long-run effects of the variables are judged by the normalised values of the long-run
multipliers. To obtain the normalised values, the estimate of the error correction term in
(10) is set to zero, giving Eq. (11), and solved for yt - 1 as shown in Eq. (12).4

γ 1 yt1 þ γ 2 xt1 ¼ 0 ð11Þ

γ2
yt1 ¼  ð12Þ
γ1

4
See Bahmani-Oskooee and Fariditavana (2015, p. 521)
 J Econ Finan

The standard error of the normalised coefficient (γγ2 ) is calculated using non-linear
1
least square techniques and the delta method as described by Pesaran and Pesaran
(1997). In order to test the validity of the long-run coefficients, we first have to establish
the existence of a long-run relationship. Thus we test the null hypothesis of Bno long
run relationship^ using the Eq. (10).

H0 : γ1 ¼ γ2 ¼ 0 vs

H0 : γ1 ≠0; γ2 ≠0

The asymptotic distribution of the F-statistic is non-standard under the null hypothesis.
Therefore, the upper and lower bounds of the appropriate critical values from Pesaran
et al. (2001) are used. If the calculated F-statistic is greater than the upper bound critical
value, the null hypothesis is rejected. Similarly, if the calculated F-statistic is smaller than
the lower bound critical value, the null hypothesis cannot be rejected. The result is
inconclusive if the calculated test statistic lies between the upper and lower bounds.
Note that Eqs. (7) to (10) do not include time trends. The time trend is omitted or
restricted based on a visual inspection of the relevant time series. The results section
clearly specifies each case.

6 Empirical results

This section presents the results from testing the four hypotheses listed in Table 1. The
results for testing the stability of the broad money multiplier using unit root/stationarity
test and the residual based cointegration test are presented in Section 6.1. The results from
using the ARDL approach to test the endogenous money theory are shown in Section 6.2.

6.1 Stability of the broad money multiplier

Table 4 shows the results from the ADF, PP and KPSS tests for unit root/stationarity of the
broad money multiplier using the regression models described in Section 5.1. The results
from the three tests reveal that the broad money multiplier in Sri Lanka is non-stationary.
In order to investigate the stability of the broad money multiplier using the second
approach we first examine the order of integration of the two time series, LM2 and LMB.
The results (see Table 5) reveal that both LM2 and LMB are integrated of order one (i.e.
I(1)) and hence the condition in case 1 can be ruled out. Therefore, the regression
Eq. (13) is estimated and residuals are tested for stationarity in order to test for case 2.

LM 2t ¼ β 0 þ β1 LRM t þ et ð13Þ

The corresponding null and alternative hypotheses are as follows.

H0 : e^t eIð1Þ vs H0 : e^t eIð0Þ

The absolute value of the calculated ADF test statistic is 1.825332, which is less
than the critical value (absolute) of 3.67. The null hypothesis cannot be rejected and we
J Econ Finan

Table 4 Unit root/stationarity test results for the broad money multiplier (M2M) with constant, no trend

Test Test statistic Conclusion

In levels In first differences

ADF −0.903598 −11.28520 M2M is I(1)

*Test critical values
1 % level −3.522887
5 % level −2.901779
10 % level −2.588280
PP −0.764497 −11.76879 M2M is I(1)
*Test critical values
1 % level −3.522887
5 % level −2.901779
10 % level −2.588280
KPSS 1.150121 0.121620 M2M is I(1)
**Test critical values
1 % level 0.739000
5 % level 0.463000
10 % level 0.347000

*MacKinnon (1996)
**Kwiatkowski et al. (1992), Table 1)

conclude that there is no cointegration between LMB and LM2. This also confirms that
the broad money multiplier is not stable. Thus both test approaches suggests that broad
money multiplier in Sri Lanka is unstable in the long-run and hence the money supply
is not exogenous and the use of the monetarist model is not supported.

6.2 Endogenous money theory based on ARDL approach

The ARDL approach described in Section 5.3 is employed to test hypotheses H0[2],
H0[3] and H0[4] listed in Table 1 under the endogenous money theory. Following the
steps outlined by Pesaran et al. (2001) and Bahmani-Oskooee and Fariditavana (2015)
an ARDL (2,0) model was found to be the optimal specification. The results for testing
causality between bank lending and monetary aggregates are presented in Section 6.2.1,
while Section 6.2.2 describes the results for the bank credit and broad money multiplier
causality test.

6.2.1 Causality between monetary aggregates and bank credit

Table 6 shows the results from the ARDL bounds test investigating the long-run
relationship between bank credit and the monetary aggregates (monetary base and
broad money). The results suggest significant long-run relationships between the
variables considered. Therefore, we compute the three normalised long-run coefficients
as described in Eqs. (10) to (12). The equilibrium correction forms of the ARDL model
 J Econ Finan

Table 5 Unit root/stationarity test results for the LM2 and LMB (with constant and trend)

Test Test statistic Conclusion

In levels In first differences

ADF
LM2 −2.501456 −4.690812 LM2 is I(1)
LMB −2.273441 −10.32589 LMB is I(1)
*Test critical values
1 % level 4.075340
5 % level 3.466248
10 % level 3.159780
PP
LM2 −1.916439 −8.131042 LM2 is I(1)
LMB −2.101326 −10.44920 LMB is I(1)
*Test critical values
1 % level −4.075340
5 % level −3.466248
10 % level −3.159780
KPSS
LM2 0.181401 0.103010 LM2 is I(1)
LMB 0.125875*** 0.115219 LMB is I(1)
**Test critical values
1 % level 0.216000
5 % level 0.146000
10 % level 0.119000

*MacKinnon (1996)
Kwiatkowski et al. (1992), Table 1)
***Significance at 10 % level

is then estimated to investigate the three causalities of interest (i) LBC → LMB, (ii)
LBC → LM2 and (iii) LM2 → LBC.
The estimated long-run coefficients for the selected ARDL model are reported in
Table 7.
The long-run coefficients for all three estimated models are positive and statistically
significant at the 1 % level. In the long run a 1 % increase in bank credit leads to an
increase the monetary base and broad money of 2.08 % and 1.18 % respectively. On the
other hand, a 1 % increase in broad money leads to an increase of 0.87 % in bank credit
in the long run.
The equilibrium correction forms of the ARDL (2, 0) model are shown in
Tables 8, 9 and 10.
As discussed in Section 5.3, a statistically significant coefficient for the error
correction term (ecm) confirms the causal relationship indicated in the first step
of the ARDL modelling. In the case of LBC →LMB (Table 8) the coefficient
J Econ Finan

Table 6 Test results from the ARDL bounds test (monetary aggregates and bank credit) - H0: No long-run
relationship

Dependant Independent F- Comparison with the critical value Conclusion

variable variable statistic

LMB LBC 9.03968 F-stat > upper bound of 7.3* at 5 % level Reject H0
LM2 LBC 8.00545 F-stat > upper bound of 7.3* at 5 % level Reject H0
LBC LM2 10.12807 F-stat > upper bound of 7.3* at 5 % level Reject H0

*Pesaran et al. (2001) case V

estimate for the error correction term is not statistically significant (calculated
t-value is less than 3.75 5) and we cannot infer that causality runs from bank
credit to the monetary base in the long run. Thus, there is no strong evidence
to establish unidirectional causality between monetary base and bank credit.
In contrast, the coefficient of the ecm term in the model for testing causality from
bank credit to broad money is statistically significant at the 5 % and has the correct sign
(see Table 9). This highly significant coefficient of ecm confirms the existence of a
long-run relationship between broad money and bank credit. The absolute value of the
coefficient of the ecm term indicates approximately 20 % of the disequilibrium of the
previous quarter’s broad money shock adjusts to the long-run equilibrium in the current
quarter.
Further, the short-run coefficient of ΔLBC is statistically significant and provides
useful information about the short-run dynamics of the model. It reveals that a 1 %
increase in the growth rates of the bank credit leads to increase broad money growth
rate by 0.35 % in the same quarter.
The results for the third equilibrium correction model, testing causality from broad
money to bank credit, are reported in Table 10.
The error correction coefficient has an estimated value of −0.305 and is highly
significant. This reveals that approximately 30 % of the disequilibrium in the previous
quarter’s shocks to bank credit adjusts back to the long-run equilibrium in the current
quarter. Further, a 1 % growth rate in broad money leads to an increase in the bank
credit growth rate of 0.56 % in the short run.

6.2.2 Causality between the broad money multiplier and bank credit

A visual inspection of the broad money multiplier does not find a deterministic time
trend (see Fig. 3). Therefore the time trend is restricted to the time series of LBC
following Pesaran et al. (2001, p. 296) and the ARDL bounds test critical values
correspond to the case IV. Table 11 presents the results of testing bidirectional causality
between the broad money multiplier and bank credit.
The null hypothesis of Bno long-run relationship^ can be rejected at the 5 % level
when the dependant variable is the LM2M. When the dependant variable is LBC the
result falls in the inconclusive region at the 5 % level. However, at the 10 % level the
null hypothesis is rejected. In such a circumstance, the ECM version of the ARDL

5
Banerjee et al. (1998, Table I panel B)
 J Econ Finan

Table 7 Estimated normalised long-run coefficients using the ARDL approach (bank credit and monetary
aggregates)

Dependant variable/Causality Independent variable Coefficient Standard error

LMB/ LBC → LMB LBC 2.08 0.45

LM2/ LBC → LM2 LBC 1.18 0.06
LBC/ LM2 → LBC LM2 0.87 0.04

Table 8 Equilibrium correction form of the ARDL (2, 0) for LBC →LMB

Regressor Coefficient Standard error t-Ratio(p-value)

ecmt - 1 −0.090584 0.063177 −1.433

ΔLMBt - 1 −0.059112 0.115402 −0.511(0.6099)
ΔLBC 0.063276 0.152169 1.138 (0.6786)
Constant 0.034165 0.013062 3.683 (0.0106)
T −0.000073 0.000196 −1.105 (0.7085)

Dependant variable: ΔLMB

model can be used as an efficient way of determining the long-run causality between
LM2M and LBC. Therefore, we compute the long run coefficients and equilibrium
correction forms of the ARDL model to investigate the causalities of (i) LBC → LM2M
and (ii) LM2M → LBC. The normalised long-run coefficient estimates are given in
Table 12.
The results indicate that in the long-run, a 1 % increase in bank credit leads
to an increase in the broad money multiplier of 0.89 % and conversely a 1 %
increase in the broad money multiplier increases bank credit by 0.1.97 %. The
equilibrium correction forms of the ARDL (2, 0) model are shown in Tables 13
and 14.
The statistically significant negative coefficients of the ecm terms confirm the long-
run causality from bank credit to the broad money multiplier and vice versa. The

Table 9 Equilibrium correction form of the ARDL (2, 0) for LBC→LM2

Regressor Coefficient Standard error t-ratio (p-value)

ecmt - 1 −0.203013 0.066361 −3.38

ΔLM2t - 1 0.192967 0.103336 1.867 (0.0655)
ΔLBC 0.352967 0.071249 4.953 (0.0000)
Constant 0.020030 0.007560 2.64 (0.0097)
T −0.000070 0.000090 −0.783 (0.4359)

Dependant variable: ΔLM2

*Compare with the Banerjee et al. (1998, Table I panel B)
J Econ Finan

Table 10 Equilibrium correction form of the ARDL (2, 0) for LM2→LBC

Regressor Coefficient Standard error t-ratio (p-value)

ecmt - 1 −0.304816 0.068456 −4.452*

ΔLBCt - 1 −0.015280 0.091746 −0.166 (0.8681)
ΔLM2 0.562624 0.134703 4.176 (0.0001)
constant −0.203013 0.009596 2.599 (0.0111)
T −0.000059 0.000125 −0.480 (0.6323)

Dependant variable: ΔLBC

*compare with the Banerjee et al. (1998, Table I panel B)

Table 11 Test results from the ARDL bounds test (broad money multiplier and bank credit) - H0: No long-run
relationship

Dependant Independent F- Comparison with the critical value Conclusion

variable variable statistic

LM2M LBC 6.446764 F-stat > upper bound of 5.15* at 5 % level Reject H0
LBC LM2M 5.112844 F-stat lies between lower bound (4.68*) upper Inconclusive
bound of (5.15*) at 5 % level

*Pesaran et al. (2001) case IV

disequilibrium of the previous quarter’s broad money multiplier returns to the long-run
equilibrium at a faster rate than bank credit in the same quarter. Further, the statistically
significant short-run coefficients reveal that 1 % increase in the growth rate broad
money multiplier leads to an increase bank credit growth rate by 0.26 % in the same
quarter. Similarly, a 1 % growth in bank credit leads to increase broad money multiplier
growth of 0.24 % in the current quarter.
Overall, the findings suggest bidirectional causality between bank credit and broad
money supply and bank credit and broad money multiplier, all of which support the
endogeneity of money supply during 1990 to 2011.

7 Conclusion and policy implications

The Central Bank of Sri Lanka’s monetary policy framework of monetary targeting is
contingent on its ability to independently control the monetary base and the existence

Table 12 Estimated normalised long-run coefficients using the ARDL approach (bank credit and broad
money multiplier)

Dependant variable/Causality Independent variable Coefficient Standard error

LM2M/ LBC → LM2M LBC 0.89 0.0269

LBC/ LM2M → LBC LM2M 1.97 0.6500
 J Econ Finan

Table 13 Equilibrium correction form of the ARDL (2, 0) for LBC→LM2M

Regressor Coefficient Standard error t-ratio (p-value)

ecmt - 1 −0.210896 0.060896 3.462*

ΔLM2Mt - 1 −0.174913 0.104920 −1.67 (0.0993)
ΔLBC 0.246276 0.124309 1.98 (0.0591)
Constant −0.001231 0.006896 −0.17 (0.8588)

Dependant variable: ΔLM2M

*Compare with the Banerjee et al. (1998, Table I panel A)

of a stable broad money multiplier, that is, the existence of a long-run relationship
between the monetary base and broad money. This paper investigates whether money is
exogenous or endogenous in Sri Lanka. Figure 1 shows clearly that the CBSL has not
been successful in achieving its final monetary policy objective of price stability. The
analysis provides a possible explanation of this failure by showing that the monetary
authorities in Sri Lanka lack exogenous control over broad money which is the
intermediate target of the monetary policy framework.
The empirical test results indicate that the broad money multiplier is not stable
during the period 1990 to 2011 and hence it is not predictable. Also, the analysis does
not reveal a long-run relationship between the monetary base and broad money.
Therefore, we conclude that money is not, as argued by monetarists, exogenous in
Sri Lanka. The results support the Post Keynesian contention that the money supply is
determined endogenously over the considered period.
The results presented in Section 6 help identify the transmission channel of
the supply of money. The lack of strong evidence for unidirectional causality
from bank credit to the money base suggests that demand for reserves is not
fully accommodated by the central bank. Bidirectional causality between broad
money supply and bank credit and the broad money multiplier and bank credit
both in the long run and short run suggests that endogenous money is created
as a result of liquidity demand on banks, that is, an independent money
demand function exists.

Table 14 Equilibrium correction form of the ARDL (2, 0) for LM2M→LBC

Regressor Coefficient Standard error t-ratio (p-value)

ecmt - 1 −0.091917 0.024640 3.829*

ΔLBCt - 1 0.145671 0.111152 1.310 (0.1937)
ΔLM2M 0.267561 0.090148 3.087 (0.0028)
Constant 0.079041 0.019417 4.070 (0.0001)
T −0.000099 0.000143 −0.698 (0.4867)

Dependant variable: ΔLBC

*Compare with the Banerjee et al. (1998, Table I panel B)
J Econ Finan

The results of this paper suggest that one reason why the CBSL has not been able to
achieve its monetary policy objectives is due to the endogenous nature of the money
supply. The finding of an unstable and unpredictable broad money multiplier indicates
that the CBSL lacks the ability to fully control the monetary base and hence the broad
money supply because money supply is created endogenously via the banking system.
This finding has important policy implications for the current monetary policy regime
in Sri Lanka. It raises the question why Sri Lanka still implements a monetary targeting
policy framework?
An important policy implication of our findings concerns the credibility of
the CBSL. If the CBSL uses the monetary targeting approach and money is
endogenous, it will have great difficulty in meeting its announced targets as
history shows. Such failure will have a negative effect on the bank’s credibility,
thus compounding the difficulty in controlling inflation, the final target of
monetary policy.
Perera (2010) argues that a number of factors prevent the prompt adoption of an
alternative to monetary targeting, namely an inflation targeting regime. Most prominent
is the weak statistical links between the operating target (the call money rate) and the
final target (inflation). However, further research is required to assess alternative
monetary policy regimes for Sri Lanka.

Appendix

M2M LRM
7 13.5

13.0
6
12.5
5 12.0

4 11.5

11.0
3
10.5

2 10.0
90 92 94 96 98 00 02 04 06 08 10 90 92 94 96 98 00 02 04 06 08 10

LM2 LBC
15 15

14
14

13
13
12

12
11

11 10
90 92 94 96 98 00 02 04 06 08 10 90 92 94 96 98 00 02 04 06 08 10

Fig. 3 Plots of M2M, LRM, LM2 and LBC

 J Econ Finan

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