Exchange rate dynamics and the trade balance : the case of Sri Lanka Public Deposited

http://ir.library.oregonstate.edu/concern/graduate_thesis_or_dissertations/0c483n71p

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  • Relationship between the exchange rate and the trade balance is a key component for a developing nation. Although, in theoretical sense, depreciation of currency would result in an improvement in the trade balance, sluggish response of trade flows to changes in currency has prompted researches to look in to the possible existence of a pattern. Studies conducted in this regard have predominantly tested for two such patterns i.e. the J-curve and the S-curve. J-curve theory postulates that depreciation would worsen the trade balance in the short-run before improving in the long-run. In contrast, S-curve theory postulates that in a general equilibrium model, there would be a positive correlation between the current exchange rate and future trade balance and a negative correlation between the current exchange rate and past trade balance. This study employs data from Sri Lankan bilateral and industry level trade in analyzing both curves. For the J-curve, the study employs the ARDL cointegration approach and error correction techniques. Cross-correlation functions are used to analyze the S-curve. Results demonstrate that for Sri Lanka, occurrence of the J-curve is not as strong as it would be compared to a developed nation mainly because (1) of data aggregation and (2) the possibility that Sri Lankan trade may not follow the assumptions made in deriving the J-curve. Underlying drivers as trade policies and supply demand shocks could be incorporated into the analysis of the J-curve for more comprehensive results. The study concludes that S-curve analysis should be considered preliminary and could be used as a precursor for further analyses.
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