Money Supply and Exchange Rate Variations in Sri Lanka in the Independent Float Regime—A Time Domain Study

The monetary model of exchange rate determination holds that cheap monetary policy of the home country leads to depreciation of the national currency. The study attempts to enquire if the rupee/dollar exchange rate variation as observed in the period of independent float regime in Sri Lanka had any link with the domestic money supply. The study of cointegration testifies that exchange rate and M2 money supply are cointegrated at level. Causality from the VEC model reveals that seven and nine month lagged money supplies cause depreciation of exchange rate. The intervention analysis through the impulse response functions and variance decomposition shows that in the forecast periods ahead there is an increasing role of money supply in the variation of exchange rate.