Determinants of exchange rates in Kenya: 1970-2005

Abstract

The study examines both structural and short-run factors determining variations of real exchange rates (RER) and nominal exchange rates (NER) in Kenya. The structural factors exam ined are terms of trade (TOT), net capital flows (NCF), balance of trade (BOT) and trade policy while short-run factors are fiscal and monetary policies. Results from analysis showed that balance of trade in most cases was insignificant while terms of trade, net capital flows, nominal exchange rate policy and monetary policy were very significant in determining variations in real exchange rates. Monetary and expansionary fiscal policies tend to reinforce depreciating effects on nominal exchange rate and terms of trade on real exchange rate. The inflationary effects of these policies also tend to undermine international competitiveness that the real exchange rate depreciation was supposed to enhance. Therefore, a real exchange rate policy which strikes a balance between the need for a real exchange rate at a sustainable long-run level and the need to prevent destabilizing effects on the domestic price level is desirable.