Effectiveness of the interest rate channel as a mean of monetary transmission in Sri Lanka

This study investigates whether the interest rate has a significant negative impact on investment. For an interest rate channel to support the achievement of monetary policy objectives, the prevalent interest elasticity of investment should be high and assume a negative value. The present study applies the co-integration and vector error correction tests to estimate the long run model and the short run dynamics of investment and independent variables; using interest rate, income, exchange rate and price level. Results show that the interest rate is negatively related to investment, with a coefficient value of 0.06. This negative relationship proves that low interest rates can negatively influence investment to achieve monetary policy objectives. A marginal effect on investment (based on the magnitude of coefficient) is not enough to maintain the efficiency of monetary policy.

 

According to Sri Lankan experience, price level and income are positively related to investment in the long run, while the nominal exchange rate is negatively related to investment. According to short run dynamics, (-71%) of the disequilibrium in investment will be adjusted towards equilibrium within a one year period.