The monetary targets were then translated into a permissible level of credit to the private sector by commercial banks after allowing for the impact of the behaviour of the external sector and the credit requirements of the government.” This is a classic characterisation of an annual monetary programme, which is a crucial element in monetary aggregate targeting. Based on Irving Fisher’s Quantity Theory of Money, monetary aggregate targeting seeks to explain the relationship between money growth and nominal economic growth (which is the combination of real economic growth and inflation). In this framework, as monetary policy instruments attempt to influence the final objective of inflation by first affecting monetary aggregates, broad money supply was considered the intermediate target. For operational purposes, reserve money or base money, which could be influenced and monitored by the Central Bank on a daily basis, was considered the operating target. The operating target and the intermediate target, both being monetary aggregates, were linked to each other through the money multiplier. 9  An Evolving Exchange Rate System While monetary aggregate targeting remained the framework for the conduct of monetary policy in Sri Lanka, the exchange rate regime also underwent a gradual evolution. The managed floating exchange rate system broadly remained a crawling band arrangement as the margin associated with the foreign exchange transactions was increased from time to time.
In order to defend the managed float, the Central Bank raised its policy interest rates to unprecedented levels, which later proved not only to be an unsuccessful exercise but also a costly experiment, which largely contributed to the only negative annual real GDP growth rate of the country’s history of -1.5 per cent in 2001. This prompted the Central Bank to revisit its exchange rate policy. On 23rd of January 2001, the Central Bank took the major step of allowing the commercial banks to determine the exchange rate depending on the supply and demand of foreign exchange in the domestic foreign exchange market. With this move, the Central Bank refrained from announcing daily buying and selling rates of foreign exchange, thus allowing freer foreign exchange transactions. The change in the exchange rate regime resulted in an overshooting effect with the rupee depreciating by Rs.13 from Rs. 98 per US dollar within the first three days, but a relatively quick stabilisation of the exchange rate followed. As the use of monetary policy to defend the foreign exchange rate was no longer necessary under the floating exchange rate regime, the Central Bank of Sri Lanka was able to conduct monetary policy with an increased focus on achieving the Bank’s objective of price stability. However, maintenance of price stability came under heavy pressure under this regime whenever aggregate demand was excessive as a result of expansionary fiscal policies.