The Effect of Exchange Rate Volatility on Inflation Rates in Kenya

Abstract

Exchange rate stability is one of the main factors that promote total investment, price stability and stable economic growth. The main objective of this study was to investigate the effect of exchange rate volatility on inflation rates in Kenya. Descriptive design deemed the best strategy to fulfill the objectives of this study. This study covered a period of less than 10 years i.e. (2003 - 2013). In this research, secondary data was collected from Central Bank of Kenya. Average US Dollar exchange rates and inflation rates for the years of study were used. The analysis used Auto Regressive Integrated Moving Average (ARIMA) models describe the current behavior of variables in terms of linear relationships with their past values. A regression model was applied to determine the relative relationship between exchange rate volatility and Inflation rate. The test indicated that there was moderate relationship between foreign exchange rates volatility and inflation rates. On carrying out an Analysis of Variance tests (ANOVA) and at 95% confidence level, it was found out that there was an insignificant relationship between exchange rates volatility and inflation rates. Using t-statistic table, the relationship can be seen to be strong, negative but not significant.. From this study it has been demonstrated that even though there is a relationship between exchange rates and inflation the relationship has a number of weaknesses. Exchange rates cannot be used to reliably predict movement in inflation rates. This is because the model used by the study showed there was an insignificant relationship between foreign exchange and inflation rates. To model a comprehensive study, future scholars should focus on using other alternate currencies such as the Euro to model this relationship.