This study aims to analyse the impact of exchange rate changes on the trade balance and to construct the effective exchange rate index using the simulated trade balance effects of the exchange rate changes as the weights. The study is divided into four sections. Section I reviews various indices of effective exchange rates highlighting their uses and limitations. Section II presents a multilateral trade model appropriate to primary commodity exporting countries. The model is employed to analyse the effects of both the nominal and real exchange rate changes during 1971-1985 on the trade balance of Sri Lanka. The results are discussed in Section III. Section IV concludes the study highlighting the major observations limitations and further research to be undertaken.
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