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This paper examines empirical evidence on monetary policy and inflation performance across exchange rate regimes in Sri Lanka. The criterion used to examine inflation performance is the degree of inflation persistence. Three alternative definitions of inflation persistence are used to model inflation dynamics. First, autocorrelation properties of inflation process are examined. Estimates of traditional Phillips curve and the hybrid-new Keynesian Phillips curve (H-NKPC) suggest a significant upward shift in inflation persistence following the change in exchange rate system in late 1977. Recursive estimates of coefficient on lagged inflation and Chow parameter stability tests confirm these results. Second, inflation response to systematic monetary policy actions is examined. Results suggest that inflation is more persistent and monetary policy is more accommodative in the flexible exchange rate regime. However, the correlation between money growth and inflation is found to be modest. Finally, inflation response to non-systemic policy actions (i.e., policy shocks) is examined through impulse response functions of an unrestricted VAR system. Results suggest that policy shocks are more persistent in the flexible exchange rate regime, than in the fixed exchange rate regime. However, maximum lag length of inflation response to a policy shock is not significantly different across regimes, suggesting that results from the impulse response analysis are inconclusive. Overall, there is substantial evidence to suggest that the shift in inflation persistence coincides with the change in exchange rate regimes. Moreover, during the flexible regime, higher monetary accommodation has resulted in higher inflation persistence. Because of sluggish response of inflation to changes in monetary policy measures, more stringent monetary policy measures may be needed to curb inflationary pressures.(JEL E 31, E 52) Key Words: Inflation Persistence, Monetary Policy, Exchange Rate Regimes DOI: 10.4038/ss.v37i1.1227 Staff Studies Volume 37 Numbers 1& 2 2007 p.69-117

Monetary Policy and Inflation Performance: Evidence from Exchange Rate Regimes in Sri Lanka