The J Curve Exposure Analysis of the Effective Exchange Rates

This study aims to find the relationship between real effective exchange rate and trade balance in Sri Lanka in order to find out the J curve phenomenon by using its 10 major trading partners. This paper first constructed the Nominal Effective Exchange Rate (NEER)and Real Effective Exchange Rate (REER)for Sri Lanka and then applied the Engle-Granger technique to investigate the long run cointegration relation between Balance of Trade (BOT) and REER, and finally employed the Error Correction Mechanism to explore the short-run linkage. Estimate results demonstrated that the REER has not a significant influence on Sri Lankan Trade Balance. The Granger Causality test suggests that the REER does not Granger cause the trade balance. We found that the Marshal-Lerner condition does not exist in Sri Lanka. Therefore, no evidence found to support the J curve theory in Sri Lanka. This implies that exchange rate policy is not an efficient policy tool in Sri Lanka. In order to improve the trade balance, Sri Lanka has to follow some other methods. Import tax policies can be imposed to reduce imports on selective basis and export promotion to increase the government revenue.