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The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka

Received: 10 June 2023     Accepted: 29 June 2023     Published: 6 July 2023
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Abstract

Exchange rate can be explained as one of the key factor, which emphasis countries macro-economic stability. As an emerging market Sri Lanka is mainly focused on international markets and highly depend on international trade. This study is on the influence of interest rate (Weighted Average Call Market Rate - CR) and inflation (Colombo Consumers' Price Index (CCPI) - INF), to the exchange rate (USD/LKR - NEXR). The research analysis monthly data of CR, NEXR and CF for the period of October 2000 to March 2013 based on Vector Error Correction Model. This research uses stationary test, cointegration test, stability test, impulse response function, residual test has generated to compile and analysis data. Results of the study proves that the exchange rate has negative relationship with interest rate for the given period. However, the exchange rate shows positive relationship with inflation. Those relationships are significant in long run causality, where it takes much more time to become equilibrium position. Further, there is no short run causality as well. The negative relationship between exchange and interest rates creates a favorable environment to capital inflows to the country. However, manipulation of exchange rate volatility by the relevant market players will lead to a change in the expected relationship of the variables. According to the results, policy makers should estimate most appropriate policy interest rate level in Sri Lanka to manage sustainable growth. Further, the regulatory authorities should manage appropriate intervention mechanisms to the foreign exchange market to control exchange rate to avoid market manipulations.

Published in International Journal of Economic Behavior and Organization (Volume 11, Issue 3)
DOI 10.11648/j.ijebo.20231103.11
Page(s) 107-124
Creative Commons

This is an Open Access article, distributed under the terms of the Creative Commons Attribution 4.0 International License (http://creativecommons.org/licenses/by/4.0/), which permits unrestricted use, distribution and reproduction in any medium or format, provided the original work is properly cited.

Copyright

Copyright © The Author(s), 2023. Published by Science Publishing Group

Keywords

Exchange Rates, Interest Rates, Inflation Rates, Vector Error Correction Model, Cointegration Test, Causality

References
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[3] Jayasena, P. (2007). Adjustment of the Financial and corporate sector to the rise in exchange rate volatility and their policy implications: the case of sri Lanka.
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[7] Utami, S. T. and Inanga, E. L. (2009) Exchange Rates, Interest Rates, and Inflation Rates in Indonesia: The International Fisher Effect Theory. International Research Journal of Finance and Economics, 26, 151-169.
[8] Hakkio, C. S. (1986). Interest Rate and Exchange rates - what is the relationship. Economic Review.
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[11] Ivrendi, M., & Guloglu, B. (2010). Monetary shocks, exchange rates and trade balances: Evidence from inflation targeting countries. https://www.sciencedirect.com/journal/economic-modelling, Volume 27, Issue 5, September 2010, Pages 1144-1155.
[12] Cavoli, T. (2008). The exchange rate and optimal monetary policy rules in open and. Economic Modeling Elsevier.
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[21] Frankel, J. A. (1979). On the Mark: A Theory of Floating Echange Rates Based on Real Interest rate Differentials. The American Economic Review.
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[23] Markopoulos, S. P. (2012). The Monetary Approach to the Exchange Rate Determination for a “Petrocurrency”: The Case of Norwegian Krone. International Atlantic Economic Society 2012.
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[25] MacDonald, R. (2007). Exchange Rate Economics - Theories and evidence. Ronald MacDonald by Park Square, Milton Park, Abingdon, Oxon OX14 4RN.
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Cite This Article
  • APA Style

    Morawaggoda Kankanamalage Tharaka Nayana Hansi. (2023). The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka. International Journal of Economic Behavior and Organization, 11(3), 107-124. https://doi.org/10.11648/j.ijebo.20231103.11

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    ACS Style

    Morawaggoda Kankanamalage Tharaka Nayana Hansi. The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka. Int. J. Econ. Behav. Organ. 2023, 11(3), 107-124. doi: 10.11648/j.ijebo.20231103.11

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    AMA Style

    Morawaggoda Kankanamalage Tharaka Nayana Hansi. The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka. Int J Econ Behav Organ. 2023;11(3):107-124. doi: 10.11648/j.ijebo.20231103.11

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  • @article{10.11648/j.ijebo.20231103.11,
      author = {Morawaggoda Kankanamalage Tharaka Nayana Hansi},
      title = {The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka},
      journal = {International Journal of Economic Behavior and Organization},
      volume = {11},
      number = {3},
      pages = {107-124},
      doi = {10.11648/j.ijebo.20231103.11},
      url = {https://doi.org/10.11648/j.ijebo.20231103.11},
      eprint = {https://article.sciencepublishinggroup.com/pdf/10.11648.j.ijebo.20231103.11},
      abstract = {Exchange rate can be explained as one of the key factor, which emphasis countries macro-economic stability. As an emerging market Sri Lanka is mainly focused on international markets and highly depend on international trade. This study is on the influence of interest rate (Weighted Average Call Market Rate - CR) and inflation (Colombo Consumers' Price Index (CCPI) - INF), to the exchange rate (USD/LKR - NEXR). The research analysis monthly data of CR, NEXR and CF for the period of October 2000 to March 2013 based on Vector Error Correction Model. This research uses stationary test, cointegration test, stability test, impulse response function, residual test has generated to compile and analysis data. Results of the study proves that the exchange rate has negative relationship with interest rate for the given period. However, the exchange rate shows positive relationship with inflation. Those relationships are significant in long run causality, where it takes much more time to become equilibrium position. Further, there is no short run causality as well. The negative relationship between exchange and interest rates creates a favorable environment to capital inflows to the country. However, manipulation of exchange rate volatility by the relevant market players will lead to a change in the expected relationship of the variables. According to the results, policy makers should estimate most appropriate policy interest rate level in Sri Lanka to manage sustainable growth. Further, the regulatory authorities should manage appropriate intervention mechanisms to the foreign exchange market to control exchange rate to avoid market manipulations.},
     year = {2023}
    }
    

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  • TY  - JOUR
    T1  - The Impact of Interest Rate and Inflation Rate Towards Exchange Rate: A Case of Sri Lanka
    AU  - Morawaggoda Kankanamalage Tharaka Nayana Hansi
    Y1  - 2023/07/06
    PY  - 2023
    N1  - https://doi.org/10.11648/j.ijebo.20231103.11
    DO  - 10.11648/j.ijebo.20231103.11
    T2  - International Journal of Economic Behavior and Organization
    JF  - International Journal of Economic Behavior and Organization
    JO  - International Journal of Economic Behavior and Organization
    SP  - 107
    EP  - 124
    PB  - Science Publishing Group
    SN  - 2328-7616
    UR  - https://doi.org/10.11648/j.ijebo.20231103.11
    AB  - Exchange rate can be explained as one of the key factor, which emphasis countries macro-economic stability. As an emerging market Sri Lanka is mainly focused on international markets and highly depend on international trade. This study is on the influence of interest rate (Weighted Average Call Market Rate - CR) and inflation (Colombo Consumers' Price Index (CCPI) - INF), to the exchange rate (USD/LKR - NEXR). The research analysis monthly data of CR, NEXR and CF for the period of October 2000 to March 2013 based on Vector Error Correction Model. This research uses stationary test, cointegration test, stability test, impulse response function, residual test has generated to compile and analysis data. Results of the study proves that the exchange rate has negative relationship with interest rate for the given period. However, the exchange rate shows positive relationship with inflation. Those relationships are significant in long run causality, where it takes much more time to become equilibrium position. Further, there is no short run causality as well. The negative relationship between exchange and interest rates creates a favorable environment to capital inflows to the country. However, manipulation of exchange rate volatility by the relevant market players will lead to a change in the expected relationship of the variables. According to the results, policy makers should estimate most appropriate policy interest rate level in Sri Lanka to manage sustainable growth. Further, the regulatory authorities should manage appropriate intervention mechanisms to the foreign exchange market to control exchange rate to avoid market manipulations.
    VL  - 11
    IS  - 3
    ER  - 

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Author Information
  • Faculty of Arts, University of Colombo, Colombo, Sri Lanka

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