Oct 11, 2010 (LBO) – Sri Lanka is “unlikely” to announce direct targeting of reserve money next year and will rely more on “traditional instruments” as the country moves gradually to target inflation directly with rates, central bank Governor Nivard Cabraal said. But under such a framework interest rates can be volatile, because the quantity of money rather than the rate is targeted.
An exchange rate peg serves as an ‘external anchor’ for price levels and sets US dollar inflation as a floor (which is almost always positive) and any additional T-bill purchases can push inflation higher.
Such purchases of ‘domestic assets’ also de-stablizes the peg leading to foreign exchange shortages and balance of payments crises. Such monetary arrangements are called ‘soft pegs’.
Sri Lanka’s high inflation, currency depreciation and eventually a closed economy started after a money printing central bank was created in 1950 abandoning an earlier currency board also known as a ‘hard peg’, which printed money only through peg interventions.
Some level of stability can also be maintained if liquidity injections are only limited to overnight markets and longer term rates are allowed to match the real credit demand and savings in the ec