The effect of selected Macro Economic Variables on exchange Rates in Kenya

Abstract

The study sought to determine the effect of the macroeconomic variables on exchange rates in Kenya. The macroeconomic variables considered were interest rate differential, inflation rate differential, Balance of payment and terms of trade. The KSH/USD exchange rate was used as the dependent variable. The development of literature was guided by interest rate parity theory, purchasing power parity and the balance of payment theory. The descriptive research design was used in this study. Secondary data was used to analyze the effect of the macroeconomic variables on exchange rates and was obtained from the Central Bank of Kenya, Kenya National Bureau of Statistics, World Bank, International Monetary Fund and the USA Federal Reserve for a period of twenty years ranging from 1995 to 2014. Data was analyzed using SPSS and multiple linear regression was used to model the relationship between the explanatory variables and the response variable by fitting a linear equation to the observed data. The study findings were that interest rate differential, balance of payment and terms of trade had a negative effect on exchange rate while inflation rate differential had a positive effect on exchange rates in Kenya. The study concludes that higher interest rates in Kenya in relation to the trading partner lead to the appreciation of exchange rate, higher levels of inflation result in the depreciation of exchange rate, improvement in the balance of payment appreciates the exchange rate while increases in terms of trade appreciates the exchange rate. The study recommends inflation rate in Kenya should be contained and the Treasury bill rate should be set high enough to attract foreign investment in the country. The study also recommends that the production of goods and services should be encouraged with the aim of increasing the exports and decreasing the imports which in turn improves the balance of payment and the terms of trade which further strengthens the Kenyan currency against foreign currency