Abstract:
The determination of the real exchange rate, tracing and forecasting its behaviour has
been in the issue that had not received the attention that it deserves. This study
models the dynamics of real exchange rate behaviour in Sri Lanka. The model is
extended following the analysis of Natural Real Exchange approach. In the long run
real exchange rate is cointegrated with nonstationary variables of terms of trade,
productivity of nontradables, productivity of tradables, government expenditure and
debt. Most of the impulse response analysis reveal that fall in terms of trade and
productivity of tradables, and rise in productivity of nontradables and government
debt have depreciated the real exchange rate of Sri Lanka in the long run. Medium
term fluctuations of the real exchange rate are driven by the changes in the long run
variables and the other stationary variables of domestic interest rate, current account
deficit and budget deficit.
