The Relationship between the Exchange Rate Volatility and Inflation in Sri Lanka

Abstract

Exchange rate volatility is also one of the factors which determine the inflation of a country. Therefore, this study aims to analyze the relationship between the exchange rate volatility and inflation in Sri Lanka over the period 1977-2020. This study has used inflation as the dependent variable. Exchange rate, export, import, money supply and foreign direct investment are used as the independent variable. Augmented Dicky- Fuller test is employed to identify the stationary of the variables. This result indicates that the variables are stationary in order one. Johansen Co-Integration test found that there is a positive and significant relationship between the exchange rate volatility and inflation, money supply and export and a negative correlation between the import. Adjustment toward the long-run equilibrium is ensured from the Vector Error Correction model result. But, there is no significant relationship in the shortrun between the exchange rate volatility and inflation. According to the CUSUM test result, the model is stable. From the Granger Causality test, exchange rate volatility has a one-way causal relationship with inflation. Therefore, this study concluded that exchange rate volatility and inflation have a long-run relation and there is no significant correlation between the variables in the short-run. Hence, this study is recommended that the Sri Lankan government must try to stabilize the exchange rate and monitor the amount of money supply within the country.