Estimation of future inflation in Sri Lanka Using arima model

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.