A study on casual relationship between inflation and exchange rates in Kenya

Abstract

This study looks at the causal relationship between inflation and exchange rates in Kenya for a period of eleven years between January 1998 and December 2008. In addition, the study also looks at whether the inflation rates can be used to determine future exchange rates and hence prove pivotal in the government decision making on the stabilization of the economy and the sustainability of the Balance of Payments. The currencies that the study looked at are the ones that are traded mostly in our currency market. They include the US Dollar, Great Britain Pound, South African Rand, Tanzania Shilling and the Uganda Shilling. The data involved was monthly data for the same period hence having a sample of one hundred and thirty two observations for each currency. The study used the Granger-Causality test to determine whether there is a causal relationship between inflation and the exchange rates in Kenya. It also used the unit roots and the cointergration tests to find out whether the time series of the data are stationary or non-stationary and the Hsiao's Procedure to determine the lag length in the autoregressive model. The study found out that there is a causal relationship between inflation and exchange rates in Kenya for only the US Dollar and the Great Britain P01md only for the short-run. ~ However, all the currencies depicted a causal relationship with the inflation rates in the long run except the Uganda shilling. Out of the results the~ one can only use the inflation differentials to predict future exchange rates for the Great Britain Pound and the US Dollar. The study found out that the inflation differentials can be used to determine the US Dollar and Great Britain Pound exchange rates both in the short-run and long-run. Nevertheless, inflation differentials can be used to determine future exchange rates only in the long run but the Uganda Shilling.