An analysis of effective exchange rate in Kenya (1970-2003)

Abstract

Since the mid 1970s, developing countries started altering their exchange rate regimes towards more flexible arrangements: The move was prompted partly by the desire to minimize the adverse effects on their economies of fluctuations in exchange rates of major currencies that took place since the advent of the generalized floating in 1973., and especially 1980s. Fundamentally, exchange, rate has become an endogenous variable , . determined by key identifiable variables, while changes in the exchange rate in turn affect important macroeconomic variables. Understanding the determinants of and sources of real exchange rate movements and their impact on the competitiveness has therefore become an important focus of policy. This paper attempts 10 calculate the effective exchange rates (nominal and real) for Kenya, and follows that with an assessment of the long-term determinants of the RER for the period 1970-2003. It identifies productivity, terms of trade, openness of the economy, foreign direct investment, and foreign real interest rate as some of the major fundamentals that drive changes in real effective exchange rate. , A recursive estimation of the real exchange rate model shows that movements in all the five fundamentals are important drivers of changes in the real exchange rate. The study shows that in order to achieve desirable economic outcome especially with regard to production and trade the Government must address the Issue of RER alongside other important policy variables, and that policies that target RER must also address these fundamentals.