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The purpose of this study is to explore the short and long term dynamics between trade deficit and its determinants such as real effective exchange rate, urbanization, inflation, trade openness and government spending in case of Sri Lanka for the period 1985 to 2018. The short run and long run analysis of the econometric model of the study is performed by ARDL bound testing approach. The findings of the study demonstrate the existence of long run relationship between trade deficit and its determinants. The results also revealed that appreciation of real effective exchange rate significantly increase the trade deficit in the long run. However the trade openness and government spending significantly reduced the trade deficit. The study prescribed that issue of trade deficit can be overcome if real effective exchange rate fluctuations, unorganized urban sprawl and government spending could be properly monitored and managed. Fiscal policies should be devised in a manner which could facilitate self-sufficiency and increase in exports, hence reduction in trade deficit. This paper contributes the literature by exploring the major determinants of trade deficit in emerging economy of Sri Lanka. It also focuses the impact of urbanization and real effective exchange rate on trade deficit. The policy implications are discussed to overcome trade deficit.

Keywords: ARDL, Government spending, Inflation, Real Effective Exchange Rate, Sri Lanka, Trade Openness, Urbanization.