Analysis of the Relationship between Inflation, Budget Deficit, and Money Supply in Sri Lanka

Abstract

Price stability, or maintaining a low and stable inflation rate, is a primary objective of an economy. Several variables can impact inflation. It is essential to identify those factors that control inflation. Therefore, this study focuses on the relationships among inflation, the budget deficit, and the money supply in Sri Lanka, using annual time-series data from 1972 to 2021. In there, the inflation rate (CPI), the budget deficit as a percentage of GDP (BD), and the consolidated broad money supply as a percentage of GDP (M2b) are considered. Using the Autoregressive Distributed Lag (ARDL) modeling approach, the relationship has been examined, considering the inflation rate as the dependent variable and the budget deficit and money supply as independent variables. According to the findings, there is a significant positive relationship between inflation and budget deficit in Sri Lanka, while the money supply has an insignificant negative relationship with inflation. Further, the study has made some recommendations, including whether the government can reduce its expenditure, especially in unproductive sectors of the economy. The government can increase its income by strengthening revenue-generating mechanisms, such as taxes. Further, necessary actions should be taken to increase the national production to accelerate economic growth. On the other hand, the monetary authorities in Sri Lanka, especially the Central Bank of Sri Lanka, should take fiscal reforms into account when conducting monetary policy.