The effect of interest rate and inflation rate on exchange Rates in Kenya

Abstract

The study sought to understand the effects of interest rate and inflation rate on exchange rates in Kenya. There are many factors that affect the exchange rate in Kenya and elsewhere in the world, but the study keenly was interested in understanding the relationship between interest rates and inflation rates on exchange rate-in Kenya. The development of literature was guided by Interest Rate Parity (IPR) Theory, Purchasing Power Parity (PPP) Theory and The Balance of Payments Theory. The descriptive research design was used in this study. Kenya Bureau of Statistics (KBA) and the Central Bank of Kenya were used as sources of information in the pursuit to establish the effects of interest rate and inflation on exchange rates in Kenya. The study used inflation rates in Percentage, interest rates in percentage and average annual exchanges rates from 20007 -2012. Multiple linear regression was used to model the relationship between two explanatory variables and a response variable was used by fitting a linear equation to observed data. Multiple regression analysis was also used to assess whether confounding exists. The study further used Test of goodness of fit and the explanatory power of the model R2 , F test ANOVA and also test of Multicollinearity. The study found that the co-efficient of multiple determinations R-square value was O. 871; this meant that the chosen variables specifically inflation rate and interest rates in Kenya during year 2007-2012 affect the exchange rate by 87.1% and therefore 12.9% effects of exchange rate ~ssociated with other unexplained factors. The regression results also indicate that the relationship between inflation and interest rates against exchanges rates is very significant at 0.05 level of significance level with a p-va1ue of 0.016. The study finally concluded that increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure and thereby helps to avoid much adverse economic consequence. The study recommends that regulators should come up with means to evaluate exchange rate volatility. It was further recommended that given specific context of developing countries like Kenya, of significant shocks from the exchange rate to inflation and the limitations related to monetary policy, controlling exchange rate volatility is very important in the fight against inflation.