Factors Influencing Inflationary Condition in Sri Lanka: Orthodox Streamlining of Influential Factors

Inflation in Sri Lanka is a key topic discussed in the open arena within last few years due to the unexpected shocks that it has created in the domestic goods and services market. The macroeconomic controls which have been tried were failed to provide the expected results in controlling this condition. Thus, the current research was directed with an objective of streamlining most significant variables which was impacted to create a volatility in the general price level of the country. Based on the literature few variables such as money supply, foreign exchange rates, treasury bill rate, gold prices, oil prices, and gross domestic production have been considered. The data was collected for 213 months for all the macroeconomic indicators and analyzed based on the descriptive and inferential statistics. The trend analysis of inflation shows a high variation of price level within the Sri Lankan economy while foreign exchange rate, gross domestic production, and money supply show a smooth trend with least shocks. Oil prices, gold prices, and treasury bill rate have structural breaks for both intercept and trend. Once the augmented Dicky-Fuller Test result confirmed the stationarity of the data at level and first difference level, with the availability of the co-integration among the variables, it was concluded to develop an error correction model (ECM) to analyze the long-run relationship between the variables while eliminating the spurious effect of ordinary least square method. Thus, the ECM confirmed that short-run coefficients of ECM are not significant and it emphasizes that the system corrects the disequilibrium of its previous period at a speed of 7.82% monthly. Since the R-squared is less than Durbin-Watson statistic, it was concluded that the ECM is not spurious. This research opens future research opportunities to enhance this model with better performance of residual diagnostics.