\citet*{Cevik_2012} study explain that the interest rate and bank lending channels are relatively effective, while the exchange rate does not appear to be important. Using the SVAR framework, they identify the empirical patterns and relative importance of different channels in transmitting monetary policy shocks in individual GCC countries and for a “synthetic” region-wide aggregate. The results of their analysis indicate that the interest rate channel influences real non-hydrocarbon output and consumer price inflation in all GCC countries as well as for the “synthetic” GCC aggregate. In contrast, the exchange rate channel does not appear to have an important role as a mechanism of monetary policy transmission. \citet*{Mishra_2012} survey the evidence on the effectiveness of monetary transmission in developing countries. They conclude that, despite methodological issues present in the literature, monetary transmission appears to be weak in developing countries. \citet{Mishra_2014} find large variation in the response of bank lending rates to monetary policy shocks across countries, with weaker transmission in developing countries.
Amarasekara (2005) examines interest rate pass-through and \citet*{Aazim_2012} examine monetary policy and yield curve dynamics. However, these studies do not focus on the transmission of the impact of interest rates into final policy variables and hence are limited to early stage of monetary transmission. Whether and to what extent monetary policy will be able to transmit its impact through different channels will depend crucially on the impact of policy rate innovations on market interest rates, and hence it deserves a closer examination (Égert and Jamilov, 2014). This study contributes to the ever growing literature on the interest-rate pass-through by evaluating its empirical importance for an emerging market economy, Sri Lanka. In relation to the transmission to final target variables, Jayamaha (1995) examines monetary transmission in Sri Lanka, but the study is limited to the early years of deregulation. Amarasekara (2008) also examines the effects of interest rate, money growth and the movements in nominal exchange rate on real GDP growth and inflation in Sri Lanka, and the results are broadly in line with the established empirical findings, especially when the interest rate is considered the monetary policy variable. Both studies of Amarasekara (2005; 2008) provide a comprehensive analysis on monetary transmission in Sri Lanka.
Data Source
The data-set used in this paper is drawn from the IMF’s International Financial Statistics, Central Bank of Sri Lanka (CBSL) and World Economic Outlook databases. The aggregate (average) monthly interest rate data are used for the period January 1997 to December 2016. In addition to the 3-month Treasury bill rates (TBR), the sample consists of average bank lending rates (LR) and deposit rates (DR). Average bank lending rates include average prime lending rates (AWPR) for licensed commercial banks (LCBs) and average lending rates (LRS) for licensed specialized banks (LSBs). Average bank deposit rates include average savings rates and average fixed deposit rates (AWDR and AWFDR) for LCBs and average deposit rates (DRS) for LSBs. Further, SVAR model use quarterly data such as real non-hydrocarbon GDP (Y), Colombo consumer prices (CCPI), a broad measure of domestic credit (DC), real effective exchange rate (ER) and the 3-month Treasury bill rates (TBR).