Econometric analysis of competing theories of inflation in Sri Lanka—Money supply or exchange rate?
EPOG+ master thesis, 2024
Sri Lanka underwent a severe balance-of-payments crisis coupled with high inflation in 2022, brought about by high foreign debt, poor trade balance, and multiple quarters of slow growth following COVID and other shocks. Historically, two prominent schools of thought in economics have explained inflation through radically different mechanisms—the monetarists believe that high inflation is always caused by excessive money supply; the post-Keynesians instead blame distributional conflicts and currency devaluation in open economies. While the Sri Lankan crisis was well-documented, causal analyses of the inflation are lacking. Further, most of the discourse is centred around the monetarist view, blaming fiscal deficit spending as the trigger of inflation. In general, literature on alternative theories of inflation is sparse in the case of South Asian countries. The present study developed two competing models to explain the 2022 inflation in Sri Lanka based on quantitative data and qualitative secondary sources—a monetarist model with money supply expansion as the cause and a post-Keynesian conflicting claims model with exchange rate fluctuation as the cause. A first econometric evaluation was conducted using autoregressive distributed lag time-series models. The econometric analysis was limited by constraints on the availability and nature of the data, and strategies are proposed to overcome these limitations in future work. In conclusion, this thesis proposes empirically founded competing models of inflation rooted in the political economy context of Sri Lanka and provides the first steps towards an econometric evaluation of the models.