Abstract:
The exchange rate and its direct and indirect impacts are widely addressed issue at present.
Exchange rate is a fundamental macroeconomic variable that affects not only for economic
performance of the particular country but also it has an impact of other countries throughout
the world. The exchange rate is a key determinant of balance of payments (BOP) of the
country. Thus, this study attempts to examine the impact of exchange rate on balance of
payment by adopting Sri Lanka data over the period of 1978 to 2016. Johansen
cointegration technique is used to identify the number of cointegrating relationship and long
run relationship, Short run relationship and long run adjustment are examined by using error
correction model. Johansen co-integration Trace test statistics and Maximum Eigen value
both are identified two co-integrating relations in the system of equation. The results of
Johansen co-integration identified exchange rate have a positive and significant long-run
relationship with balance of payment. There is a positive and significant adjustment towards
the long-run equilibrium between exchange rate and balance of payment in Sri Lanka. Error
correction coefficient (0.003) of exchange rate reveals that 0.3% (less than 1%)
disequilibrium is corrected by each year one period after the exogenous shocks which
implies that exchange rate moves downward towards the long run equilibrium path. while
error correction coefficient of balance of payment and lending interest rate move
upward towards with long run equilibrium path in each year one period after the
shocks. But other macroeconomic variables do not have adjustment towards longrun equilibrium. Finally, this study concludes either devaluation under fixed
exchange rate regime or allowing depreciation under freely floating exchange rate
regime of the domestic currency against foreign currencies can use as a short term
and long term policy measurement to correct the balance of payment imbalance
situation.
