Sri Lanka keeps rates unchanged amid slower inflation, weaker growth

 

Source: Economy Next

Title of the Article: Sri Lanka keeps rates unchanged amid slower inflation, weaker growth

Author: Staff Writer

Date of Publication: July 25, 2025

Website: www.economynext.com

 

Determination of the interest rate is a core principle in the field of monetary economics and finance, and it affects consumption, investment, inflation and general economic activity. In the Sri Lankan context, it is important to learn how the interest rates are determined by the Central Bank (CBSL) of Sri Lanka, particularly during the current macroeconomic turbulences. The paper is a critique of the interest rate decision by CBSL in July 2025 and its relationship with the theoretical models of interest rate determination.

                       

                             Source - pix4free.org/assets/library/2021-04-28/originals/economic.jpg

 

Overview of the News

In July 2025, the Central Bank of Sri Lanka opted not to change its policy interest rates, despite the evidence of a slowing economic growth and easing inflation rates. The Standing Deposit Facility Rate (SDFR) and the Standing Lending Facility Rate (SLFR) were maintained at 8.50 and 9.50 respectively. The CBSL attributed this to the necessity to maintain stability in the financial markets and to watch closely inflation expectations and the behavior of the external sector.

 

Theoretical Foundation - What Determines the Interest Rates?

The monetary policy structures and the market forces determine the interest rate. The theoretical approaches are majorly categorized into

                                  Source  s3-us-west-2.amazonaws.com/courses-images-archive-read-only/wp-

1. Loanable Funds Theory

 This theory suggests that the determination of interest rates is based on the amount of supply of funds and the demand of funds within the capital market. An increase in savings (supply of funds) will lower the interest rates and vice versa.

 

2. Keynesian

 In this theory, the interest rates are determined by the demand and supply of money. This is controlled by the central banks through money supply.

 

3. Fisher Effect

 The correlation between the real interest rates and the nominal interest rates and anticipated inflation. That is

Real Rate = Nominal Rate- Forecasted Inflation

 

4. IS-LM Model (Macroeconomic Model)

This model explains the equilibrium rate of interest with the interplay of goods market and money market (IS and LM curve respectively).

Sri Lanka, The Case - Theory to Practice

  

 

·       Monetary Policy Response to Inflation

The action by the CBSL is founded on the Liquidity Preference Theory. As inflation is on a declining path, it may be expected that to encourage investment, the interest rates will be lowered. But the central bank maintained rates unchanged, which was considered as being cautious- perhaps because of the worry about exchange rate stability and inflow of foreign capital.

 

·       Fisher Effect in action

Since the rate of inflation has decreased, maintaining the nominal rates at the same level means an increase in the real interest rates. This would chill the domestic demand and control the inflationary expectations in the long run a policy which is in line with the Fisher Effect.

 

·       Loanable Funds and Growth Trade-off

The slowdown in the economy of Sri Lanka is an indication of poor investment demand. However, the CBSL appears to be more focused on credibility of the financial market and exchange rate defense than short-term stimulation of growth, which implies the necessity to balance long-term macroeconomic objectives

                           Source - openoregon.pressbooks.pub/app/uploads/sites/14/2016/09/CNX_Econ_C03_026.jpg

·       Investor and Business Implications

The same interest rates represent that the borrowing costs will not change, but they will be rather high to financial institutions and corporate decision-makers. This will discourage new capital investments in the short run. Conversely, the foreign investors might interpret the stable rates as a stable policy, which promotes inflows of capital, particularly in the government securities mark

Conclusion

The latest interest rate setting of the Central Bank of Sri Lanka indicates the complexity of the interest rate setting where there are trade-offs between the inflation control, economic growth, and the external stability. Central banks do not work in a vacuum and put economic principles into practice in the real world where the constraints are evolving, as the July 2025 monetary policy stance shows.

 

 

 ✍  Written by: Madhushanka Rathnayaka

📆 Published on: August 03, 2025