The Impact of Inflation on Economic Growth: Evidence from Sri Lanka

Abstract

This study investigates the relationship between inflation and economic growth in Sri Lanka, a developing economy characterized by macroeconomic volatility, fiscal imbalances, and external vulnerabilities. The objective is to examine both the short-run and long-run effects of inflation on economic growth while incorporating additional macroeconomic variables, including gross fixed capital formation, labor force participation, military expenditure, and trade openness. Utilizing time-series data from 1989 to 2023 and employing the Autoregressive Distributed Lag (ARDL) model, the study captures dynamic interactions and explores causal relationships among these variables. Empirical findings reveal that inflation has a statistically significant negative impact on Sri Lanka’s long-term economic growth, as high inflation reduces purchasing power, discourages investment, and creates uncertainty, thereby undermining effective economic planning. Conversely, military expenditure and gross fixed capital formation contribute positively to growth, highlighting the potential of strategic public investment to counterbalance inflationary pressures. In the short run, inflation, trade openness, and military expenditure exhibit immediate impacts on economic growth, while the error correction term confirms a relatively swift adjustment toward long run equilibrium following economic shocks. Diagnostic and stability tests validate the robustness of the model. The study concludes that managing inflation should remain a central objective of macroeconomic policy, recommending a balanced strategy that combines inflation targeting with growth-enhancing measures such as promoting capital formation, improving productivity, and strengthening institutional frameworks. These findings offer valuable insights for policymakers, researchers, and stakeholders committed to supporting Sri Lanka’s economic recovery and fostering sustainable development.