The Impact of Monetary Variables on Exchange Rate Fluctuations in Sri Lanka

Abstract

The exchange rate is an important and useful indicator of Economic performance. High fluctuations in exchange rates create uncertainty on economic activities. USD/LKR exchange rate has depreciated continuously, ignoring small appreciations experienced from time-to-time. Therefore, this study mainly focuses on the monetary variables which affect Sri Lanka-US exchange rate. The estimation is based on 116 monthly observations from January 2010 to August 2019. Nominal exchange rate and monetary variables such as money supply, Real Income and interest rate of Sri Lanka and United State of America are studied by employing cointegration analysis and Error Correction Model. Furthermore, have used some diagnostic test and special tests to describe the time series properties of the model. The study finds that, there is no evidences to supporting short run relationships between the monetary variables and exchange rate, while there is long-term co-integrating relationships between the nominal exchange rate and monetary variables. The error correction term (ect) is quite small and insignificant, indicating that short - term deviation from long - term equilibrium is restored within more than five years. Findings are statistically significant and correct sign reported for domestic money supply and domestic real income. The results found that variables of the model led to the ability of the flexible price monetary model in explaining future exchange rate movements of Sri Lanka.