The effect of selected macroeconomic factors on exchange rate volatility in Sri Lanka

Abstract

This study intends to investigate the factors affecting exchange rate volatility of USD/LKR in Sri Lanka, in the period of January 2010 to December 2017, by using time series Vector Auto Regressive model and Pearson Correlation Coefficient. The study analyses the factors namely, Colombo share market movements, exports, imports, worker’s remittances and tourist arrivals which affect the exchange rate volatility of Sri Lanka. The results of the study indicate that to estimate exchange rate volatility ARIMA (1, 0, 0,)-GARCH (1, 0) is the best fittest model and It implies exchange rate had AR and ARCH effect only. As well as positive coefficient of GARCH model indicated there is positive impact of a magnitude of a shock (spillover effect) for exchange rate. From the results of Correlation coefficient showed evident for negative insignificant relationship between exchange rate volatility and all economic factors. It implies that there is a like hood of increases in exchange rate volatility with decrease in above mentioned economic variables and that relations is statistically insignificant. According to final VAR model The Colombo Share Market Movements and Imports showed the significant impact on the exchange rate volatility. Even though Pearson correlation coefficient concluded all the economic factors (including Colombo Share Market Movement and Imports ) using the study are negatively associate with exchange rate volatility, VAR model coefficient observed quite different result which is including Colombo Share Market Movement and Imports had positive significant relation. The main policy implication from the results of this study is that crucial to emphasize that the macroeconomic policies have to be implemented in order to stabilize and reduce the exchange rates volatility.