Abstract

This article examines the factors that affect exchange rate fluctuations in Sri Lanka. The relevance of this article relies on how do the changes in Inflation, Interest Rates, Terms of Trade, Net Foreign Purchases (a proxy for Net Capital Inflows), Official Intervention and remittances affect the fluctuations in Sri Lanka’s Exchange Rate. The article is carried out with respect to three objectives, namely; examine the factors that affect exchange rate fluctuations, identify the relationship between the factors and the exchange rate fluctuations and investigate the impact of the factors that had on the exchange rate. Two different econometric models (Multiple Regression Model and VAR Model) have been used to analyses the results, with monthly data, for the period 2001: 01 to 2010:12. Results obtained by Multiple Regression Model suggest that net official intervention is the most effective and significant determinant of exchange rate during the sample period. Inflation and net foreign purchases (as a proxy for Net Capital Inflows) are rendered to be less effective and non-significant determinants of the exchange rate. However, it can be seen that there is a direct link between the two determinants of net official intervention and net foreign purchases. A negative relationship exists between exchange rate and inflation, interest rate, remittances, and terms of trade, whereas a positive relationship exists between exchange rate and net foreign purchases. According to the estimation results of Vector Auto Regression net official intervention, net foreign purchases and call money rate cause the most of fluctuations in the exchange rate.

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