Factors Affecting Exchange Rate Variability in Sri Lanka: An Autoregressive Distributed Lag Approach

Abstract

A free float in the exchange rate has been recorded in the Sri Lankan rupee over the past few years affecting the Sri Lankan economy to a significant extent. This study intended to examine the factors affecting the exchange rate variability in Sri Lanka during the period from 1991 to 2020. For the study secondary data were obtained from the World Bank and the Central Bank of Sri Lanka. The exchange rate was considered as the dependent variable while inflation rate, merchandise trade, Gross Domestic Product (GDP) growth, foreign direct investments, balance of payments and external debt were considered as independent variables. Augmented Dickey Fuller (ADF) test was used to examine the stationary of the time series data, and Autoregressive Distributed Lag (ARDL) was adopted to figure out the long-run and short-run relationship between the variables. The results of ARDL bound test confirmed that there is a co-integration relationship between the variables, and the results of the error correction model revealed the significant impact of inflation rate, merchandise trade, Gross Domestic Product growth, foreign direct investments, balance of payments and external debt on exchange rate in both short run and long run. In the short run, balance of payment and GDP have no significant impact on the changes in exchange rate, and the results confirmed that there is a Exchange rate indicates negative relationships with external debt, inflation, and merchandise trade. Finally, the results confirmed the exchange rate is in a negative relationship with FDI and GDP in the long run.