Abstract
This article examines the factors that affect exchange rate fluctuations in Sri Lanka. It attempts to identify how the changes in inflation, interest rates, terms of trade, Net Foreign Purchases (a proxy for Net Capital Inflows), official intervention and remittances affect the fluctuations in Sri Lanka’s exchange rate. There are two specific objectives, which are identifying the relationship between the factors and the exchange rate fluctuations, and investigating the impact of the factors on the exchange rate. The Multiple Regression Model has been used to analyse the results, with monthly data, for the period 2001 to 2010. The Vector Auto Regression Model has been used an alternative specification to this model. Results obtained by the Multiple Regression model suggest that net official intervention is the most effective and significant determinant of the exchange rate during the sample period. Inflation and net foreign purchases (as a proxy for Net Capital Inflows) are reduced to be less effective and non-significant determinants of the exchange rate. However, it can be seen that there is a direct link between the two determinants of net official intervention and net foreign purchases. A negative relationship exists between the exchange rate and inflation, interest rate, remittances, and terms of trade, whereas a positive relationship exists between the exchange rate and net foreign purchases. According to the estimation results of the Vector Auto Regression model, net official intervention, net foreign purchases and call money rate cause the most fluctuations in the exchange rate.