Exploring long-run and short-run effects of macroeconomic variables on exchange rate of Sri Lanka

Abstract

This study explores the short-run and long-run effects of macroeconomic variables on the exchange rate of Sri Lanka using the Autoregressive Distributed Lag (ARDL) model with monthly data from 2010 to 2022. The research investigates how interest rates, trade balances, inflation rates, money supply and Net Foreign Assets (NFA) impact the exchange rate, providing a comprehensive analysis of these relationships over the given period of time. This study uniquely incorporates NFA into the analysis of exchange rate dynamics using the ARDL model with recent high-frequency monthly data from Sri Lanka, providing novel insights and addressing empirical gaps in the Sri Lankan context. The use of ARDL enables a robust analysis of both immediate and delayed effects, shedding light on the sensitivity of Sri Lanka's exchange rate to various economic shocks and changes. By distinguishing between short-term and long-term dynamics, the study offers a nuanced understanding of how macroeconomic factors influence the exchange rate. The findings highlighted that higher interest rates in Sri Lanka could weaken the currency by eroding investor confidence. A long-term negative association between inflation and exchange rates, with higher inflation leading to currency appreciation. Additionally, money supply exhibited a positive long-term association with exchange rates, whereas trade balance and net foreign assets showed no significant impact.