Abstract:

The varying exchange rate exerts remarkable influence on the trade balance and balance of payment. Sri Lanka is no exception to this. The nature and extend of the changes wrought by the exchange rate on the trade balance vary from country to country. The objective of this study was to investigate the relationship between exchange rate and trade balance for Sri Lanka.  The study is based on two country model involving trade between Sri Lanka and the U.S.A. This study is based on secondary data. The model I have recourse to is a model adopted by many researchers where the trade balance and real exchange rate are directly linked. The model encompasses the variable such as trade balance, real exchange rate, and real income, converted into log form. The analysis is done by the use of statistical package Eviews 6 which includes the econometric procedures of Unit root test, Engle - Granger and Johansen technique for   co- integration and also IRF analysis is done to test J curve effect. The result suggests that variables In TB, In RER, In RSL and In RUS are co- integrated. The results bring to light the fact that the real exchange rate has significantly positive influence on the trade balance of Sri Lanka both in the short- run and the long-run.  The Granger causality test confirms the fact that real exchange rate (RER) Granger causes trade balance of Sri Lanka. However there is no evidence of J curve effect for trade between Sri Lanka and USA. In contrast, devaluation improves trade balance in the short- run and continues to do so in the long-run.