Sensitivity of Exports to Change in Relative Prices and Nominal Exchange Rate: Case of Manufacturing Exports of Sri Lanka

In 1950, Orcutt argued that ‘trade flows respond to changes in nominal exchange rate faster than to changes in relative prices’. Subsequently empirical studies have tested this hypothesis and have found mixed results. The experience of Sri Lanka, where it has been encountering a relentless fall is the share of its exports in the global trade during the past decade, provides an ample motivation to test this hypothesis to ascertain which policy instruments would stimulate its export performance faster. This study tests the Orcutt’s conjecture on Sri Lanka export flows to its six major trading partners, using annual data for the period 1970 -2019. Since the data is mix of I(1) and I(0), Autoregressive Distributed Lag (ARDL) technique is employed to incorporate the dynamic adjustments of relative prices and the nominal exchange rate. The findings indicate that, in the short run, exports respond only to changes in nominal exchange rate, but does not respond to the changes in relative prices. In the long run however, exports respond to changes in both relative price and changes in nominal exchange rate. The impact of changes in exchange rate are relatively higher in both short-run and long-run. The findings of this analysis are consistent with the Orcutt’s hypothesis and suggest that nominal exchange rate would be a more appropriate policy instrument to promote export performance of the country.