Abstract:
Inflation plays a key role in macroeconomic analysis. The importance and necessity of low
and stable inflation has become a commonly prevailing viewpoint among the economist for
maintaining a stable socio-economic situation in many countries. The negative consequences
of inflation are well known. Inflation can result in a decrease in the purchasing power of the
national currency leading to the aggravation of social conditions and living standards. High
prices can also lead to uncertainty making domestic and foreign investors reluctant to invest
in the economy. Moreover, inflated prices worsen the country's terms of trade by making
domestic goods expensive on regional and world markets. Therefore, inflation is considered
to be a major economic problem in transition economies and thus fighting inflation and
maintaining stable prices is the main objective of monetary authorities.
Earlier signal of future inflation is important to make economic decision. Forecasting is the
estimation of the value of the variable (or set of variables) at some specific future point in
time. Sri Lanka uses Colombo Consumer Price Index (CCP1) to estimate inflation rates. For
most Central Banks, inflation is important monetary policy objective. Inflation forecasts that
link future inflation to current development. Some Central Banks have even adopted an
inflation forecast as an intermediate target of inflation. This proves that inflation forecast
should be reliable. Quantitative inflation forecasting can provide useful information on
future developments. Therefore, it is very important in an inflation-targeting regime to
develop powerful models that explain the dynamic movements of the economy. If the
Central Bank had a powerful inflation-forecasting model, it could be able to take preemptive
actions that reproduce the economic dynamics as well.
