Abstract:
This study aims to investigate the relationship between the exchange rate and Trade Balance. Trade Balance is used as the dependent
variable, and the independent variables are Exchange Rate, Gross Domestic Product, and Inflation. Augmented Dickey-Fuller unit root test
was adopted to test the stationary property of time series data, Auto Regressive Distributed Lag model was employed to find the long run
and short-run relationship and long-run adjustment, Bound test approach, the unrestricted Error Correction Model and Granger Causality
Test are used to analyze the data from 1977 to 2019. The research findings suggest that inflation has a positive impact on the trade balance
in the short run. The exchange rate and the Gross Domestic Product have adverse effects on Trade balance in the long run. The coefficient
of ER in the previous year is negative, and the coefficient of TB in the previous year is positive and significant. This is consistent with the
J-Curve phenomenon, which states that devaluation may not improve trade balance in the immediate period, but will significantly impact
the trade balance improvement in subsequent periods. Hence Marshall Lerner Condition exists in Sri Lanka.
