The Relationship Between the Real Interest Rate and the Real Exchange Rate in Kenya

Abstract

The project analyses the relationship between the real interest rate and real exchange rate. The project focuses on the Kenya economy and captures the period 19971 to 2013. This covers the period of both fixed and floating exchange rate regime. The high-frequency data used in the project was deemed noisy, thus the model was re-estimated in a technique that uses time-varying parameters for comparison. Theoretically, it is argued that the interest rate differential will widen as the real exchange rate appreciates, and this triggers capital to flow in. Also, domestic inflation will rise as the real exchange rate depreciates, and the influence of foreign inflation will decrease as the exchange rate appreciates. The policy lessons that emanate from these results relate to exchange rate management and interest rate structure. One of the aspects of policy dilemma argued in the paper is that the real interest rate differential and the exchange rate absorb shocks from each other. The project findings shows that closing the gap in the real interest rate by lowering the domestic interest rate will be consistently result in depreciation of the exchange rate. Ideally, the approach is not to sterilize capital flows but to allow exchange rate movements to stabilize the flows in the medium to long term. In the end, the effects on the interest rate structure will be transitory. It is therefore advisable to avoid responding to short-term capital flows. With a floating exchange rate and an open capital account. Ignoring the short term capital flows will allow the exchange rate to equilibrate reserves and determine the optimal flow of short-term capital. The findings revealed that 45 percent of changes in real exchange rates is as a result of changes in real interest rates. The findings in the study also revealed that the F Value = 14.725and P-value at 0.01 is less than 0.05. This implies that indeed interest rates negatively affect the real exchange rates. This implies that indeed interest rates negatively affect the real exchange rates. The findings agree with some findings of studies done before, that movement of short-term capital is as a result of agents’ perception of risk of domestic assets in the country and sometimes is as a result of reaction of stock adjustments to changes in prices or shocks or both. Policy intervention would distort the rates more and only lender the problem more complex.