THE EFFECT OF INFLATION ON FOREIGN EXCHANGE RATE FLUCTUATION
IN KENYA
PATRICK ILAHUYA MUSALIA
A RESEARCH PROJECT SUBMITTED IN PARTIAL FULFILLMENT OF THE
REQUIREMENT FOR THE AWARD OF MASTER OF SCIENCE IN FINANCE
DEGREE, SCHOOL OF BUSINESS, AT THE UNIVERSITY OF NAIROBI.
OCTOBER 2014
DECLARATION
I declare that this Research project is my original work and that it has not been previously
presented to any other University for examination/academic purposes.
Signature ……………………….
………………………………
MUSALIA PATRICK ILAHUYA
DATE
D63/65170/2013
The Research project has been submitted with my approval as the University supervisor.
Signature ……………………….
…………………………………..
Dr. J.O.ADUDA
DATE
SENIOR LECTURER,
DEPARTMENT OF FINANCE AND ACCOUNTING.
ii
ACKNOWLEDGEMENTS
Although I have put a lot of effort and hard work into this research project, it would not have
been possible to complete it without the blessings, guidance and protection from God
almighty and kind support and help of many individuals and organization.
I wish to express my sincere thanks and appreciation to my supervisor, Dr.Josiah Omollo
Aduda for his kindness and well executed professional and intellectual guidance offered to
me while conducting this research project. I also wish to recognize my Moderator Mr. Mirie
Mwangi for his advice and guidance which was not only reliable and perfect but very much
learning oriented.
I also wish to thank my wife and children, my parents, brothers and sisters as well as my
friends for their encouragement and support during the period of conducting this study. I
sincerely thank you very much for your prayers and well wishes for my success.
May the Almighty God bless you all in abundance?
iii
DEDICATION
This research project is dedicated to my loving wife Mary and children, Ellyjiver and
Constance for their moral and emotional support while carrying out the study. Without their
encouragement and understanding, I would not have accomplished this task.
iv
ABSTRACT
Exchange rate is one of the main macroeconomic variables that affect the economy of a
country. Exchange rate affects the level of investment in a country, price stability and the
balance of trade. Various macroeconomic factors have been identified by various authors as
contributing to fluctuation in exchange rate. This includes among others relative inflation,
interest rates, income levels, government interventions and market expectations. The aim of
this study was to investigate the relationship between movement in inflation and exchange
rate fluctuation in Kenya. The study relied on the hypothesis of purchasing power parity
theory which states that exchange rates between currencies are in equilibrium when their
purchasing power is the same in each of the two countries. The exchange rate between two
countries should equal the ratio of the two countries' price level of a fixed basket of goods and
services. When inflation increases in a country, that country's exchange rate must depreciate
in order to return to PPP. The research aimed at establishing the extent to which the PPP
theory holds in Kenya. The research was for a period of nine years from January 2005 up to
December 2013.Secondary data for exchange rate movement were obtained from the Central
Bank of Kenya while data for inflation was obtained from the Kenya National Bureau of
Statistics. This two are government institutions and therefore the credibility of data was
assured. Regression analysis was applied to analyze the data in order to establish the
relationship that exists between the two variables. The result from data analysis indicates the
existence of a negative relationship between movement in inflation and exchange rate
fluctuation in Kenya during the period of study.
v
Table of Contents
DECLARATION ....................................................................................................................... ii
ACKNOWLEDGEMENTS ...................................................................................................... iii
DEDICATION .......................................................................................................................... iv
ABSTRACT............................................................................................................................... v
LIST OF TABLES .................................................................................................................. viii
LIST OF ABBREVIATIONS ................................................................................................... ix
CHAPTER ONE ...................................................................................................................... 1
1.1
Background ................................................................................................................ 1
1.1.1 Inflation .................................................................................................................. 2
1.1.2 Foreign Exchange Rate Fluctuations ..................................................................... 3
1.1.3 Relationship between Inflation and Exchange Rates Fluctuations. ....................... 4
1.1.4 Inflation and Foreign Exchange Rates in Kenya. .................................................. 5
1.2
Research Problem ...................................................................................................... 7
1.3
Objective of the Study ............................................................................................... 8
1.4
Value of the Study ..................................................................................................... 8
CHAPTER TWO ................................................................................................................... 10
LITERATURE REVIEW ................................................................................................. 10
2.1
Introduction .............................................................................................................. 10
2.2
Theories of Inflation Vs Exchange Rates ................................................................ 10
2.2.1 Purchasing Power Parity Theory ......................................................................... 10
2.2.2 International Fisher Effect Theory ....................................................................... 12
2.2.3 Interest Rate Parity Theory .................................................................................. 14
2.2.4 Quantity Theory of Money .................................................................................. 14
2.3
Determinants of Exchange Rate Fluctuations .......................................................... 15
2.4
Review of Empirical studies .................................................................................... 17
2.5
Summary .................................................................................................................. 23
RESEARCH METHODOLOGY ......................................................................................... 25
3.1.
Introduction .............................................................................................................. 25
3.2.
Research Design....................................................................................................... 25
3.3
Research Population................................................................................................. 25
3.4
Research Sample ...................................................................................................... 26
3.5
Data Collection. ....................................................................................................... 26
3.6
Data Analysis. .......................................................................................................... 27
DATA ANALYSIS AND PRESENTATION OF FINDINGS ............................................ 28
4.1
Introduction .............................................................................................................. 28
4.2
Data Presentation ..................................................................................................... 28
vi
4.2.1 Descriptive Statistics ............................................................................................ 28
4.2.2 Correlation and Regression Analysis. .................................................................. 30
4.3
Summary and Interpretation of Findings ................................................................. 32
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS ....................................... 34
5.1
Summary .................................................................................................................. 34
5.2
Conclusion ............................................................................................................... 35
5.3
Policy Recommendations......................................................................................... 36
5.4
Limitations of the Study........................................................................................... 37
5.5
Suggestions for Future Studies ................................................................................ 38
APPENDIX 1 .......................................................................................................................... 43
vii
LIST OF TABLES
Table 1: Descriptive Statistics ................................................................................................. 28
Table 2: Correlation Matrix ..................................................................................................... 30
Table 3: Analysis of Variance (ANOVA) ............................................................................... 31
Table 4: Correlations................................................................................................................ 31
Table 5: Model Summary ........................................................................................................ 32
viii
LIST OF ABBREVIATIONS
ANOVA
-
Analysis of Variance
CBK
-
Central Bank of Kenya
CPI
-
Consumer Price Indices
GDP
-
Gross Domestic Product
IFE
-
International Fisher Effect
IT
-
Information Technology
IRP
-
Interest Rate Parity
KNBS
-
Kenya National Bureau of Statistics
KSHS
-
Kenya Shillings
NSE
-
Nairobi Securities Exchange
PPP
-
Purchasing Power Parity
PPI
-
Producer Price Index
QTM
-
Quantity Theory of Money
RPI
-
Retail Price Indices
RBI
-
Reserve Bank of India
RER
-
Real Exchange Rate
SPSS
-
Statistical Package for Social Sciences
US
-
united States
USD
-
United States Dollar
VAR
-
Vector Autoregressive
ix
CHAPTER ONE
1.1
Background
As suggested by Danjuma (2013), exchange rate is one of the most important determinants of
a country's relative level of economic health. Changes in exchange rates have powerful effects
on the terms of trade of countries concerned through effects on relative prices of goods and
services. Exchange rates determine the prices of imported goods relative to domestic goods.
Similarly, they determine the competitiveness of domestic goods in the international market.
The importance of exchange rates in determining the balance of trade cannot be
overemphasized and this makes policy makers worry about the behavior of both nominal and
real exchange rates and also have active interest in their determination.
The relationship between prices and exchange rates is one of the classic topics studied in
international macroeconomics. This relation is of interest both from a positive and normative
perspective. One basic hypothesis connecting prices and exchange rates is that of relative
purchasing power parity (PPP) which proposes that changes in prices of goods should be the
same across locations when converted into a common currency. Deviations in relative PPP
can arise because of differences in the cost of supplying the goods to different locations or
because firms price discriminate across locations by charging different mark-ups (Burstein et
al, 2013).
Review of empirical studies also shows that inflation is one of the major factors affecting
foreign exchange rates. The more open the economy, the greater the importance of the
exchange rate in the policy process. It is generally expected that all other factors remaining
the same, when inflation in a country increases, its products become expensive in the
international market leading to reduced demand for the local currency. Imports become cheap
and demand for foreign currencies increase. Both of these forces place a down word pressure
on the high inflation country’s currency (Case et al, 2009).
1
Exchange rate and monetary policies are also key tools in economic management and in the
stabilization and adjustment process in developing countries, where low inflation and
international competitiveness have become major policy targets. The real exchange rate is a
measure of international competitiveness. Inflation mostly emanates from monetary
expansion, currency devaluation and other structural factors (Ndung’u, 2000).
1.1.1
Inflation
Inflation is a situation in an economy where there is a persistent rise in the general level of
prices of goods and services over a period of time. When the general price level rises, each
unit of currency buys fewer goods and services. Inflation also reflects erosion in the
purchasing power of money (Hagger, 1977).
There are two main types of inflation differentiated by their causes; demand pull inflation and
cost push inflation. Demand pull inflation is brought about by an increase in demand for
commodities while the supply remains the same. The increase in demand arises mainly from
an increase in incomes of the individuals. This leads to a situation where a lot of money is
chasing for a few available commodities in the market resulting in increase in prices.
Cost push inflation on the other hand is caused by an increase in the production cost of the
commodities. When the price of raw materials, labor and power among others increases, the
cost of production increases and the same is passed to consumers through pricing.
Chhibber (1991), when analyzing a group of African countries, found out that inflation
emanates from four major sources: Cost-push factors from discrete currency devaluations,
demand-pull forces when there is excess demand created by excessive credit expansion in the
economy, balance of payments crises and controlled prices widely deviating from market
prices and whose re-adjustment creates an inflationary shock.
2
The most common methods of measuring inflation discussed and referred to in the financial
markets are the percentage increase or decrease of Consumer Price Indices (CPI) and Retail
Price Indices (RPI). These monthly statistical indices are constructed from the price of a
basket of goods and services deemed representative of the households’ consumption patterns
in a geographical area. The percentage change of the CPI over a period of time is what is
usually referred to as inflation.
1.1.2
Foreign Exchange Rate Fluctuations
Foreign exchange rate is the rate at which one currency will be exchanged for another. It is
the price of a nation’s currency in terms of another currency. An exchange rate has two
components, the domestic currency and a foreign currency, and can be quoted either directly
or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms
of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is
expressed in terms of the foreign currency. An exchange rate that does not have the domestic
currency as one of the two currency components is known as a cross currency, or cross rate
(Madura, 2000).
The systems used in foreign currency exchange have evolved from the gold standard, to fixed
exchange rate to a floating exchange rate system. Under the gold standard system which
operated from 1876 to 1913, each currency was convertible into gold at a specified rate. The
exchange rates between two currencies were determined by their relative convertibility rates
per ounce of Gold.
The Bretton woods agreement of 1944 lead to the establishment of a fixed exchange rate
system. The system which operated until 1971 allowed governments to intervene and prevent
exchange rates from moving more than 1% above or below their initially established levels
(Madura, 2000).
3
To a large extent, the fixed exchange rate set by the Bretton woods agreements served as
international monetary arrangements until 1971. In 1971, the United States and most other
countries decided to abandon the fixed exchange rate system in favor of a floating or marketdetermined exchange rate. Although governments still intervene to ensure that exchange rate
movements are orderly, exchange rates today are largely determined by the unregulated
forces of supply and demand (Case et al, 2009).
In a floating exchange rate regime, the exchange rate is a price freely determined in the
market by forces of supply and demand. The dollar is purchased by foreigners in order to
purchase goods or assets from the United States. Likewise, U.S. citizens sell dollars and buy
foreign currencies when they wish to purchase goods or assets from foreign countries. The
exchange rate is determined by whatever rate clears these markets (Labonte, 2004).
1.1.3
Relationship between Inflation and Exchange Rates Fluctuations.
The earliest theory explaining the relationship between exchange rate and inflation is the
purchasing power parity theory. According to PPP theory, inflation rates vary among
countries, causing international trade patterns and exchange rates to adjust accordingly. When
a country’s inflation rates rises the demand for its currency declines as its exports decline due
to their high prices. In addition, consumers and firms in that country tend to increase their
imports. The theory bases its predictions of exchange rate movement on changing patterns of
trade due to different inflation rates between countries (Madura, 2000)
A high level of inflation in a country relative to the other countries puts pressure on the
exchange rate between the two countries. There is a tendency for the currency of the
relatively high inflation country to depreciate. When a country’s currency depreciates, its
imports price rises. On the other hand, its exports prices in foreign currency fall. A
depreciation of a country’s currency can serve as a stimulus to the economy as domestic
products become attractive to foreign buyers (Case et al, 2009).
4
1.1.4
Inflation and Foreign Exchange Rates in Kenya.
Over the recent years, Kenya has experienced a rapid increase in prices of consumer goods.
Statistics from the KNBS indicate a continuous fluctuation in inflation reaching a high of
46% in 1993 and a low of 1.6% in 1995. Indeed, the annual inflationary rate in Kenya has
been above 10% for most of the years since the year 2000.
The recent surge in inflation in Kenya can be attributed to various factors ranging from
macroeconomic imbalances to supply-side constraints and external pressures factors.
Empirical studies have arrived at varied conclusions on the causes of inflation in Kenya.
Duravall & Ndung’u (1999) in the study on dynamics of inflation in Kenya found that
Exchange rate, foreign prices and terms of trade have long-run effects on inflation, while
money supply and interest rates only have short-run effects. They also established that the
dynamics of inflation are also influenced by food supply constraints. Similarly, Duravall et al
(2012) showed that excess money supply, exchange rates, food and non-food world prices,
world energy prices and domestic agricultural supply shocks are the main causes of inflation
in Kenya.
Kenya's exchange rate policy has undergone various regime shifts over the years, largely
driven by economic events, especially balance of payments crises. A fixed exchange rate was
maintained in the 1960s and 1970s, with the currency becoming over-valued, though not
extremely so. Exchange controls were maintained from the early 1970s until a marketdetermined regime was adopted in the 1990s (Ndung’u, 2000).
Exchange rate regimes in Kenya have been influenced through historical government
macroeconomic policy from fixed exchange rate regimes to pegged and later floating through
liberalization in the nineties. Since then, the exchange rates have been characterized by
significant fluctuations. For instance, data from CBK shows that the exchange rate of Kenya
Shillings per USD in December 2004 was Kshs. 77.34 per USD. In October 2011, the shilling
5
had depreciated and was exchanging at the rate of Kshs. 105.961 per USD. However, the
shilling started to strengthen again and by December 2013, the exchange rate was Kshs.
86.3097 per USD (Data from CBK website).
Previous studies in Kenya have attributed the fluctuation in the exchange rate to various
macroeconomic factors. Kiptoo (2007) in his research thesis on real exchange rate volatility
and misalignment in Kenya concluded that real exchange rate volatility was due to both
external and internal fundamentals which include terms of trade and net capital flows as well
as productivity growth and trade policy determined by the degree of openness. Musyoki et al
(2012) on the other hand concluded that the volatility in exchange rate was as a result of
adoption of the floating exchange rate regime in the country.
Kiptui & Kipyegon (2008) study which investigated the effect of external shocks on the real
exchange rate in Kenya showed that oil prices and openness have significant effects on the
real exchange rate. The study also found that though external shocks have major effects on
the real exchange rate, domestic shocks also play a part .The results show that the interest rate
differential has significant negative (appreciating) effects in the short and long run. On the
other hand, government spending has significant positive (depreciating) effects on the real
exchange rate in the short-run and long-run while real GDP growth has positive
(depreciating) effects in the short-run but negative (appreciating) effects in the long-run.
6
1.2
Research Problem
According to purchasing power parity theory, in the absence of transportation costs, the price
of same commodities should be the same in both the domestic and foreign country. The
exchange rate between the two countries would then be determined simply by the relative
prices in the two countries. A high inflation rate in one country relative to the other would in
this case put pressure on the exchange rate leading to depreciation in value of the currency of
the country with higher inflation.
A review of literature reveals few studies have been conducted to establish the effect of
inflation on exchange rate. Moreover, very few studies attempts to establish statistical
relationship between inflation and exchange rate fluctuation as theoretically proposed through
purchasing power parity theory. Most of the studies also differ on the most ideal causes of
exchange rate fluctuation and inflation volatility.
For instance, while Moser (1995) argues that the precipitous depreciation of the parallel
exchange rate was the principal determinant of inflation in Nigeria, Chibber (1991) found that
excess demand created by excessive credit expansion, balance of payment crisis and
controlled prices were the main causes of inflation in Ghana. On the other hand, Duvarall &
Ndung’u (1999) concluded that the proximate determinants of prices in the long run are
exchange rate, foreign price level and the terms of trade.
Rose (1996) argues that exchange rate regime does matter in explaining exchange rate
volatility, on the other hand, Burney & Akhtar (1992) in their study on government and
exchange rate determination in Pakistan found that exogenous and policy induced shocks
influence real exchange rates.
Rutasitara (2004), in the study on the exchange rate regimes and inflation in Tanzania
concludes that the impact of foreign prices and exchange rate depends on the existing pricing
arrangements, which in Tanzania ranged from controls to free market while Musyoki et al
7
(2012) in the study on Real Exchange Rate (RER) Volatility in Kenya concluded that
government policy of adopting floating exchange rate regime has not achieved the intended
purpose for which it was established, namely to reduce RER misalignment.
As seen from the conclusions above, despite purchasing power parity theory hypothesizing
the existence of a theoretical relationship between exchange rate and price of commodities,
empirical studies in Kenya has been minimal. Moreover, the few studies done in Kenya and
elsewhere have arrived at different contradicting conclusions as shown above.
The aim of this research is to fill this gap by providing empirical evidence through data
analysis to show the impact of inflation on exchange rate fluctuation in a freely floating
exchange rate regime in Kenya.
1.3
Objective of the Study
This study is aimed at determining the relationship that exists between inflation and foreign
exchange rate fluctuation in Kenya. The study will use figures for CPI to establish the impact
of inflation on foreign exchange rates in Kenya
1.4
Value of the Study
The findings of this study will be of great importance to the government, business community
as well as the general public. The study is of great importance to the Government Policy
makers as it will help in understanding the extent to which inflation volatility influence
movement in exchange rate. The knowledge is of great importance during policy formulation
to counter exchange rate fluctuation.
The research is also very important to the business community especially those dealing with
international trade. The study will provide them with a better understanding of the effects of
inflation on exchange rates. This knowledge will enable them to make the right decisions that
will increase their returns during inflationary period.
8
Moreover, the research is significant to the general public as it creates awareness on the
causes of exchange rate fluctuation. The consumers will be able to have a better
understanding of how inflation impacts on exchange rates and consequently on prices of
imports as well as exports. This knowledge will enable the consumers to make the precise
decisions on types of products to consume during inflationary period.
9
CHAPTER TWO
LITERATURE REVIEW
2.1
Introduction
A review of literature was undertaken to support the study carried out in this research project.
A general survey was first conducted to familiarize myself with the research gaps before the
research topic was settled on, after which a more detailed review was done. This chapter on
the literature review contains a review of the empirical studies that have been conducted in
multiple locations and across multiple time periods on the relationship between exchange rate
movement and inflation. These findings are supported by details of the theories explaining
particular relationship between inflation and exchange rates.
2.2
Theories of Inflation Vs Exchange Rates
A review of literature on inflation in Kenya and elsewhere reveals a variety of conclusions
drawn. Indeed, even though a number of studies on inflation and exchange rates exist, there is
no consensus on which theory is the most adequate. This review demonstrates that each
theory holds at a particular time in a particular setting and explains some economic
fundamental such as inflation, interest rate, government policy and future expectations.
2.2.1
Purchasing Power Parity Theory
Also known as the law of one price, purchasing power parity theory states that in the absence
of trade barriers and transportation cost between two countries, the price of same goods
should be roughly the same in both countries. If the law of one price held for all goods and if
each country consumed the same market basket of goods, the exchange rate between the two
countries would be determined simply by the relative prices in the two countries.
10
The theory proposes that exchange rates will adjust so that the price of similar goods in
different countries is the same. In practice however, transportation costs for many goods are
quite large and the law of one price does not hold for these goods. Also, many products that
are potential substitutes for each other are not precisely identical (Case et al, 2009).
According to purchasing power parity theory, inflation rates vary among countries, causing
international trade patterns and exchange rates to adjust accordingly. When a country’s
inflation rates rises the demand for its currency declines as its exports decline due to their
high prices. In addition, consumers and firms in that country tend to increase their imports.
Both these forces place down ward pressure on the high-inflation country’s currency. The
theory bases its predictions of exchange rate movement on changing patterns of trade due to
different inflation rates between countries (Madura, 2000).
The absolute form of purchasing power parity is based on the notion that without international
trade barriers and transport costs, consumers shift their demands to wherever prices are lower.
It suggests that prices of the same basket of products in two different countries should be
equal when measured in a common currency. If a discrepancy in prices as measured by a
common currency exists, the demand should shift so that these prices converge.
The minimum preconditions for absolute PPP include: First, Same production technology for
individuals, second, Neutral-risk preferences, third, Perfectly competitive goods markets in
two different economies and finally, no trade barriers such as transport costs, tariffs and trade
quotas, and so on. Realistically, the preconditions for absolute PPP do not hold since transport
costs, tariffs, and technological and preferential differences exist at all times and places and as
such absolute PPP is rejected by most empirical surveys (Madura, 2000).
The relative form of purchasing power parity accounts for the possibility of market
imperfections of transportation costs, tariffs and quotas. This version acknowledges that
because of these market imperfections, prices of the same basket of products in different
11
countries will not necessarily be the same when measured in a common currency. It does
state, however, that the rate of change in prices of the baskets should be somewhat similar
when measured in a common currency.
According to relative purchasing power parity exchange rate should adjust to offset the
differential in inflation rates of the two countries. If this occurs, the prices of goods in the two
countries should appear similar to consumers. That is, the relative purchasing power when
buying products in one country is similar to when buying products in the other country. The
theory therefore suggests that the exchange rate will not remain constant but will adjust to
maintain the parity in purchasing power (Madura, 2000).
PPP does not however consistently occur because of confounding effects. PPP presumes that
exchange rate movements are completely driven by inflation differential between two
countries. However, change in currency spot exchange rate is influenced by the other factors
including interest rates, income levels, government controls and future expectations.
The concept behind PPP theory is that as soon as the prices become relatively higher in one
country, consumers shift their demand to the other country. The shift influences the exchange
rate. However, if substitute goods are not available in the other country, then consumers may
not shift their demand to that other country. Therefore PPP does not hold in the absence of
substitutes for some traded goods (Madura, 2000).
2.2.2
International Fisher Effect Theory
The International Fisher Effect (IFE) theory explains the relationship between the interest rate
differentials of two countries and the expected exchange rate changes. The derivation of this
relationship according to the IFE is that the actual return to investors who invest in money
market securities in their home country are the foreign interest rate and the change in the
foreign currency value (Madura, 2000).
12
According to IFE theory, if real interest rates are the same across countries, any difference in
nominal interest rates could be attributed to the difference in expected inflation. IFE theory
suggests that foreign currencies with relatively high interest rates will depreciate because the
high nominal interest reflects expected inflation. The nominal interest rate would also
incorporate the default risk of an investment.
The IFE theory disagrees with the notion that a high interest rate in a country will entice
investors from various countries to invest there and place upward pressure on the currency.
By considering the effect of inflation conditions associated with a high interest rate, the IFE
theory suggests that difference in nominal interest rates could be attributed to the difference in
expected inflation (Madura, 2000).
IFE theory concludes that when home interest rate is higher than foreign interest rate, the
foreign currency value will be positive, since the relatively low foreign interest rate reflects
relatively low inflationary expectations in the foreign country. The foreign currency will then
appreciate, as the foreign interest rate will be lower than the domestic interest rate. This
appreciation would then increase the foreign returns to investors in the home country, thereby
moving returns on foreign securities close to returns on home securities.
On the other hand, when home interest rate is lower than foreign interest rate, the foreign
currency value will be negative, because the foreign currency will depreciate when the
foreign interest rate exceeds the domestic interest rate. This depreciation will tend to reduce
the returns on foreign financial securities and make them unattractive to domestic investors in
the financial securities in the home country money market to yield higher returns.
The generalized version of the IFE theory specifies a relationship between interest rates
differential of two countries and their inflation rates differential which eventually affects the
value of currency of each country. Countries with high rates of inflation should have higher
nominal interest rates than countries with lower rates of inflation.
13
2.2.3
Interest Rate Parity Theory
IRP theory states that the interest rate differential between two countries is equal to the
differential between the forward exchange rate and the spot exchange rate. Interest rate parity
plays an essential role in foreign exchange markets, connecting interest rates, spot exchange
rates and foreign exchange rates. The theory further states that the size of the forward
premium or discount on a foreign currency should be equal to the interest rate differentials. In
equilibrium, the forward rate differs from the sport rate by a sufficient amount to offset the
interest rate differential between two currencies.
If IRP theory holds then arbitrage is not possible in international investment. The theory
states that no matter whether an investor invests in domestic country or foreign country, the
rate of return will be the same as if an investor invested in the home country when measured
in domestic currency.
If domestic interest rates are less than foreign interest rates, foreign currency must trade at a
forward discount to offset any benefit of higher interest rates in foreign country to prevent
arbitrage. However, if foreign currency does not trade at a forward discount or if the forward
discount is not large enough to offset the interest rate advantage of foreign country, arbitrage
opportunity exists for domestic investors. Domestic investors can benefit by investing in the
foreign market.
If domestic interest rates are more than foreign interest rates, foreign currency must trade at a
forward premium sufficient enough to offset any benefit of higher interest rates in domestic
country to prevent arbitrage. Otherwise arbitrage opportunity will exist for foreign investors
who can benefit by investing in the domestic market.
2.2.4
Quantity Theory of Money
The concept of the quantity theory of money (QTM) began in the 16th century. As gold and
silver inflows from the Americas into Europe were being minted into coins, there was a
14
resulting rise in inflation. This led economist Henry Thornton in 1802 to assume that more
money equals more inflation and that an increase in money supply does not necessarily mean
an increase in economic output (Mankiw & Taylor, 2011).
The quantity theory of money states that there is a direct relationship between the quantity of
money in an economy and the level of prices of goods and services sold. According to QTM,
if the amount of money in an economy doubles, price levels also double, causing inflation.
The consumer therefore pays twice as much for the same amount of the good or service.
Essentially, the theory's assumptions imply that the value of money is determined by the
amount of money available in an economy. An increase in money supply results in a decrease
in the value of money because an increase in money supply causes a rise in inflation. As
inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost
more to buy the same quantity of goods or services (Mankiw & Taylor, 2011).
2.3
Determinants of Exchange Rate Fluctuations
Numerous factors determine exchange rates fluctuations and all are related to the trading
relationship between two countries. Before considering why an exchange rate changes, it’s
important to realize that exchange rate at a given point in time represents the value of a
currency. Like any other products sold in the market, the price of a currency is determined by
the demand for that currency relative to supply. The equilibrium exchange rate will therefore
change over time as supply and demand schedules change. The principal determinants of
changes in demand and supply of a currency are as discussed below (Madura, 2000).
2.3.1 Relative Inflation Rates
As discussed before, relative inflation rates can affect international trade activity. An increase
in inflation in a country, leads to an increase in demand for imports which appear cheaper. On
the other hand, exports reduce as the domestic products become expensive in the international
15
markets. The increase in demand for imports leads to an increase in demand for foreign
currency and an increase in supply of local currency. The exchange rate will therefore
increase in favor of the foreign currency. Inflation therefore appear to have a negative relation
with exchange rate movements
2.3.2 Relative Interest Rates.
Changes in relative interest rates affect investment in foreign securities. Increase in interest
rates reflects an increase in expected returns which attracts investors. In line with this, an
increase in interest rates in a country increases the demand for its currency which leads to a
shift in exchange rate in favor of the country. The impact of higher interest rates is mitigated,
however, if inflation in the country is much higher than in others, or if additional factors serve
to drive the currency down.
2.3.3 Relative Income Levels
An increase in income levels in a country leads to an increase in in demand for both local and
foreign products. Other factors remaining the same, an increase in individual incomes in a
country leads to an increase in demand for foreign currency which leads to a shift in exchange
rate in favor of the foreign currency.
2.3.4 Government Controls
Governments can influence equilibrium exchange rates in many ways. This include; Direct
intervening through buying and selling of currencies in the foreign exchange markets,
imposing foreign exchange barriers, imposing foreign trade barriers and lastly by affecting
the macro variables such as inflation, interest rates and income levels which have been
discussed above.
16
2.3.5 Expectations
Foreign investors inevitably seek out stable countries with strong economic performance in
which to invest their capital. Like other financial markets, foreign exchange markets react to
any news that may have a future effect. A country with a positive attributes will draw
investment funds away from other countries perceived to have more political and economic
risk. Political turmoil, for example, can cause a loss of confidence in a currency and a
movement of capital to the currencies of more stable countries.
2.4
Review of Empirical studies
Since the adoption of floating exchange-rate regimes by most countries, the effects of
exchange-rate volatility on the volume of international trade have been the subjects of both
theoretical and empirical investigations. This section deals with review of past studies relating
to exchange rate fluctuation and inflation volatility.
Burney & Akhtar (1992) in their study on government and exchange rate determination in
Pakistan found that exogenous and policy induced shocks influence real exchange rates
through four channels namely; absolute prices, relative prices, income and interest rates. The
relative importance of each of the channels for a particular country depends on a number of
country specific factors. In this context, government budget deficits through their linkages
with price level, interest rates and growth of money supply are believed to have an indirect
effect on the real exchange rate.
Sebastian (2006), in his research paper on the relationship between inflation targeting and
exchange rates addressed three specific issues: first, he analyzed the effectiveness of nominal
exchange rates as shock absorbers in countries with inflation targeting. Secondly, he
investigated whether exchange rate volatility is different in countries with an inflation
targeting regime than in countries with alternative monetary policy arrangements. And
thirdly, he discussed whether the exchange rate should play a role in determining the
17
monetary policy stance under inflation targeting.
The main findings from this analysis were summarized as follows: First, countries that have
adopted IT have experienced a decline in the pas-through from exchange rate changes to
inflation. In many of the countries in the sample this decline in the pass-through has been
different from CPI inflation than for PPI inflation. Secondly, the adoption of IT monetary
policy procedures has not resulted in an increase in (nominal or real) exchange rate volatility.
However, in three out of five countries the adoption of a floating exchange rate regime
increased the degree of volatility of exchange rates. And finally, there is some evidence that
IT countries with a history of high an unstable inflation tend to take into account explicitly
developments in the nominal exchange rate when conducting monetary policy.
Kamin & Klau (2003) empirically found that there is a relationship between inflation and the
real exchange rates in most countries of Asia and Latin America. Furthermore, they found
that the effect of exchange rates changes on inflation in Latin America was significantly
higher than those in Asia and industrialized countries.
Mohanty & Bhanumurlthy (2014) study focused on the impact of exchange rate regime on
inflation in India during different episodes of exchange rate stability. The results from this
study showed that the impact of exchange rate regime on inflation is not visible in Indian
case, which could be because of the offsetting sterilization policy undertaken by Reserve
Bank of India (RBI) during expansionary money supply growth resulting from its large scale
intervention to even out exchange rate volatility.
Haderi et al. (1999) and Muço et al. (1999) in their study on inflation in Albania shows that,
for the early transition years (1993-96), the exchange rate and remittances explained much
more of the variation in inflation than changes in the money supply.
18
Chhibber (1991), when analyzing a group of African countries, found out that inflation
emanates from four major sources: Cost-push factors from discrete currency devaluations,
demand-pull forces when there is excess demand created by excessive credit expansion in the
economy, balance of payments crises and controlled prices widely deviating from market
prices and whose re-adjustment creates an inflationary shock.
Chhibber & Shafik (1992) developed a macroeconomic model of inflation which they used to
study the impact of depreciation of currency to inflation in Ghana between1965-1988. This
study suggests that the growth of money supply is one key variable explaining the Ghanaian
inflationary process. Such variables as official exchange rate and real wages could not exert
any significant influence on inflation. However, significant positive relationship was found to
exist between the parallel exchange rate and the general price level.
Similarly, Moser (1995) concluded that the devaluation of the Nigerian currency (Naira) was
an important variable in the inflationary process in Nigeria. He found out that concurrency
fiscal and monetary policies had a major influence on the impact of the depreciation of the
Naira on inflation.
Oriavwote (2012) in the research paper on the relationship between the real exchange rate and
inflation in Nigeria showed that there is a long run relationship between inflation and the real
exchange rate. The result showed that both domestic and imported inflation appreciated the
real exchange rate. The ARCH result indicates the persistence of volatility between the rate of
inflation and the real exchange rate. He concludes that the real exchange rate in Nigeria has
been susceptible to fluctuations in the rate of inflation.
The research paper by Imimole & Enoma (2011) examined the impact of exchange rate
depreciation on inflation in Nigeria for the period 1986 –2008. The research found that
exchange rate depreciation, money supply and real gross domestic product are the main
determinants of inflation in Nigeria, and that Naira depreciation is positive, and has
19
significant long-run effect on inflation in Nigeria. The paper also found that inflationary rate
in Nigeria has a lagged cumulative effect. The research paper therefore concludes that
although Naira depreciation is relevant in ensuring an improvement in the production of
exportable commodities, it must not be relied upon as a potent measure for controlling
inflation in Nigeria.
Oyejide (1989) observed that exchange rate depreciation often leads to increased local
currency cost of imported inputs (raw materials and intermediate capital goods) and final
goods via the cost-push inflation channel. He noted that since non tradable goods cannot be
imported, an excess demand for them would translate into increased prices given the fixed
nature of domestic supply in the short-run. This price increase according to him feeds directly
into domestic inflation via the demand-pull route.
Barungi (1997) in his research on exchange rate policy and inflation in Uganda found that
inflation in Uganda was persistently a monetary phenomenon. The monetary financing of the
fiscal deficit was found to be the main cause of sustained inflation in Uganda. In addition to
the links between fiscal deficit and monetization, the study also investigated the causal
relationship between exchange rate and fiscal balance. The major conclusions are that
monetary expansion as denominated by the financing of the fiscal deficit is instrumental in
determining the pace of inflation.
Rutasitara (2004) in the study on the exchange rate regimes and inflation in Tanzania
concludes that the impact of foreign prices and exchange rate depends on the existing pricing
arrangements, which in Tanzania ranged from controls to free market. In an economy with
price controls, they have a restraining effect on inflation and therefore suppress inflation.
However in a market driven economy, fluctuations in exchange is easily transmitted to
domestic prices.
20
Ndung’u (1994) in the research on causes of inflation in Kenya found out that money supply
drives inflation .He however concluded that there is only a short run relationship between
these variables: deviations from equilibrium in money market do not enter the model and thus
money does not determine the price in the long run.
Duravall & Ndung’u (1999) in their study on inflation in Kenya between 1974-1996 found
that the proximate determinant of prices in the long run are exchange rate ,foreign price level
and the terms of trade ,while the money supply and interest rates only have short term effects.
They also concluded that the dynamics of inflation are also found to be influenced by food
supply constraints.
McPherson & Rakovski (2000) in their study on exchange rates and economic growth in
Kenya used data for the period 1970 to 1996 to analyze the possible direct and indirect
relationship between the real and nominal exchange rates and GDP growth in Kenya. The
estimation results from the data analysis showed that there is no evidence of a strong direct
relationship between changes in the exchange rate and GDP growth. Rather, Kenya’s rate of
economic growth has been directly affected by fiscal and monetary policies, the availability
of foreign aid and other economic variables, particularly the growth of exports. They
concluded that improvements in exchange rate management alone are not adequate for the
revival of growth in Kenya, but have to be part of a broader program of economic reform.
Kiptoo (2007) focused on RER volatility and misalignment on international trade and
investment for the period 1993 to 2003. The results from the analysis showed that in the long
run, Kenya’s equilibrium RER is only affected by real variables which may be either
categorized as external or internal fundamentals. The former fundamentals were terms of
trade and net capital flows while the latter fundamentals were productivity growth and trade
policy proxied by the degree of openness.
21
Sifunjo & Mwasaru (2012) examined the causal relationship between foreign exchange rates
and stock prices in Kenya from November 1993 to May 1999. The data set consisted of
monthly observations of the NSE stock price index and the nominal Kenya shillings per US
dollar exchange rates. The objective was to establish the causal linkages between leading
prices in the foreign exchange market and the Nairobi Securities Exchange (NSE). The
empirical results from this study show that foreign exchange rates and stock prices are nonstationary both in first differences and level forms, and the two variables are integrated of
order one, in Kenya.
Musyoki et al (2012) study on Real Exchange Rates (RER) misalignment in Kenya found that
actual RER was more often above its equilibrium value for the study period of June 1993 –
December 2009 and the country’s international competitiveness deteriorated over the study
period. The study used Johansen Cointegration and error correction technique based on single
equation and Vector Autoregressive (VAR) specification. The conclusion drawn from these
results is that the adoption of the floating exchange rate regime has not achieved the intended
purpose for which it was established, namely to reduce RER misalignment, and in particular
RER overvaluation.
Otuori (2013) research journal sought to investigate the determinant factors of exchange rates
and their effects on the performance of commercial banks in Kenya. The results showed that
interest rate and terms of trade had positive and significant effects on performance while
inflation rate and external debt had negative and significant effects on performance. The study
concluded that higher levels of interest rate lead to higher profitability in commercial banks in
Kenya. The study further concluded that higher levels of inflation rate result in lower bank
profitability in Kenya. The study also concluded that higher levels of external debt result in
lower bank profitability in Kenya. Lastly, the study concluded that higher levels of exports
and imports lead to higher profitability in commercial banks.
22
Ouma et al (2013) journal whose purpose was to determine the trend of foreign exchange
rates fluctuation of Kenya’s main trading currencies, the US Dollar, the Euro and the UK
Pound. The study used secondary data collected between the periods January, 2006 to
December, 2010 from the Central Bank of Kenya website in establishing the existing trend of
foreign exchange rates fluctuation in Kenya. The findings revealed the existence of positive
trend in US dollar and the Euro exchange rates and negative trends in UK pound exchange
rates.
2.5
Summary
The review of literature on inflation and exchange rate above demonstrates that each
theory/empirical study holds in a particular setting and explains some economic fundamental
such as inflation, interest rate, government policy and future expectations. Moreover, Results
of the different studies are difficult to compare since the sample period, model specification,
countries and the economic variable of study vary widely.
Purchasing power parity (PPP) theory is covered in the initial part of this literature review as
a starting point for understanding how exchange rates are determined in the goods market. It
builds linkage between the exchange rate and prices of goods in two economies. The Fisher
Effect theory specifies the relationship between interest rates differential and their inflation
rates differential which eventually affects the value of currency of each country.
A review of literature on exchange rates as discussed also reveals a variety of conclusions
drawn. Burney and Akhtar (1992) identified government budget deficits through its linkages
with price level, interest rates and growth of money as having an indirect effect on the real
exchange rate. Karim and Klau (2003) established that inflation plays a role in exchange rate
fluctuation. Otuori (2013) identifies interest rates, inflation rates, terms of trade, and public
debt as the main causes of exchange rate fluctuation.
23
On the other hand, a review of literature on inflation also reveals a variety of conclusions
drawn Chhibber (1991) concludes that inflation is caused by demand pull and cost push
factors. Rutasitara (2004) while studying on inflation in Tanzania shows that the major cause
of inflation was the pricing arrangement which ranges from controls to free market. Other
studies including; Chhibber and Shafik(1992), Barungi(1997) and Ndung’u and
Duravall(1999) points at money supply, exchange rate and food supply as the key causes of
inflation in developing economies.
24
CHAPTER THREE
RESEARCH METHODOLOGY
3.1.
Introduction
This chapter outlines the research methodology that was used in this study. This includes the
research design, target population, sample size and justifications. The chapter also outlines
the, type of data used, data collection method and statistical technique used to analyze the
data.
3.2.
Research Design
A research design is the plan, structure and strategy of investigation, conceived so as to obtain
answers to research questions (Kerlinger, 1973). Descriptive research is very common in
business and other aspects of life and it’s used to determine relationships between variables.
The research design has been applied in this study to establish the relationship between
inflation and foreign exchange rate.
The design was appropriate because the study involved an in depth study of two variables:
inflation and exchange rate. The purpose of this research was to explain the correlation
between inflationary volatility and exchange rate fluctuation in Kenya for the period 2005 up
to 2013.
3.3
Research Population.
As Fricker (2013) stated, a population is the total collection of elements about which we wish
to make some inferences. It is the collection of all possible observations of a specified
characteristic of interest.
The population for exchange rates was the foreign exchange rates of Kenya shilling against
all currencies of the other countries in the world. On the other hand, the population for
inflation was the CPI for all commodities in Kenya for the period of the research.
25
3.4
Research Sample
A sample is a group of people, objects, or items that are taken from a larger population for
measurement. The sample should be representative of the population to ensure that we can
generalise the findings from the research sample to the population as a whole.
In this research, the sample exchange rate selected was the Kenya Shilling against the US
dollar. The reason for sampling the US dollar against other currencies is that most of the
international commercial transactions in Kenya are done using the US dollar. It’s therefore
most likely that if inflation has any effect on exchange rate, then, this can be clearly shown
through Changes in exchange rate between Kenya Shilling and the US dollar.
The research covered the period between 2005 and 2013. Statistics from the KNBS and CBK
shows that during the sampled period, there was an increasing trend in inflation coupled with
depreciation of the Kenya shillings in relation to the US dollar. This is therefore the ideal
period for establishing if the inflation had any impact on the exchange rate.
3.5
Data Collection.
The data employed in this study was time series secondary data. The exchange rate figures
that were used are the average monthly exchange rate of Kenya shillings per US dollar. The
inflation figures used in the study are the average monthly inflationary rates as reported by
the KNBS.
The data for exchange rate figures was obtained from the CBK website while the inflationary
trend figures were obtained from K.N.B.S. These are credible institutions which compile the
above economic data on behalf of the government. The data provided is therefore unbiased,
accurate and reliable.
26
3.6
Data Analysis.
In order to find the relationship between inflation and exchange rate, monthly data of the
same variables were used from 2005 to 2013. Pearson product moment correlation and trend
analysis was used in the analysis of the data. Abnormal figures were catered for by ignoring
the specific periods during data analysis.
This research was based on the following simple linear regression model:
Et
= Et-1 +∆INF (Et-1) + ∈
Where
Et
=
is the current exchange rate
Et-1
=
is the exchange rate at the end of the previous year.
∆INF =
is the change in Kenya inflation rates within the year.
∈
is the error term. Represents changes in exchange rate caused by the other
=
factors like interest rates, individual income, government policy and
expectations.
The data was entered into the Statistical Package for Social Sciences (SPSS) and analyzed
using correlation and regression analyses.
27
CHAPTER FOUR
DATA ANALYSIS AND PRESENTATION OF FINDINGS
4.1
Introduction
This chapter summarizes the findings from the collected data and gives interpretation for the
same. The data gathered was analyzed using statistical package for social sciences (SPSS)
generating descriptive statistics as well as correlation and regression coefficients. Microsoft
Excel was used for other quantitative comparative analysis.
4.2
Data Presentation
The data collected was input into excel and SPSS computer packages and the summary of
results obtained is as shown in the tables and graphs below.
4.2.1
Descriptive Statistics
This is a set of brief descriptive coefficients that summarizes the characteristics of the data for
both inflation and exchange rate. The measures used to describe the data set are measures of
central tendency and measures of variability or dispersion. The results are as summarized in
table one below.
Table 1: Descriptive Statistics
N
Minimum Maximum
Mean
Std. Deviation
INFLATION
102
3.09
31.50
12.0950
7.69985
EXCHANGER
ATE
102
61.90
87.48
76.8467
6.87412
Valid N
(listwise)
102
Source: Results from data analysis
Results of descriptive statistics analysis shown in table one above shows that the minimum
28
value of inflation during the period was 3.09% while the maximum value was 31.50%.The
mean inflation was 12.1% while the standard deviation was 7.7%. This low standard
deviation indicates that inflation in Kenya did not fluctuate too much from an average of
12.1% during the period under study.
The minimum value of exchange rate during the period was 61.9 while the maximum value
was 87.48. On average exchange rate in Kenya during the period under study was 76.85 with
a standard deviation of 6.87%. This low standard deviation implies that exchange rate in
Kenya did not deviate so much from the mean of 76.8467 during the period of study.
Although the movement in both variables appears to have been stable during the period as
indicated by the low standard deviation, we can however conclude that on average the
fluctuation in inflation from the mean during the period was high as indicated by the standard
deviation of 7.7% as compared to fluctuation in exchange rate from the mean which stood at
6.87%.
Time Series Analysis.
Source: Results from data analysis in excel
The graphs for time series analysis for both exchange rate and inflation depict a number of
29
peaks and lows during the period. The period between April and December 2008 indicates the
highest peak in inflation and the lowest low in exchange rate. There are other peaks and flows
which appear to be erratic for both the graphs during the period. It therefore appears that there
is a lot of unpredictability in movement in inflation and exchange rate.
4.2.2
Correlation and Regression Analysis.
The correlation between variables measures the degree of linear association between them.
Regression analysis on the other hand shows the effect of the independent variable (inflation)
on movement in the dependent variable(exchange rate).The results from the data analysis for
both correlation and regression are as summarized in tables two to five below.
Table 2: Correlation Matrix
Coefficients
Unstandardized
Coefficients
Model
B
(Constant)
Standardized
t
Sig.
Coefficients
Std. Error
81.183
1.171
-.358
.082
Beta
69.348
.000
-4.384
.000
1
INFLATION
-.402
Dependent Variable: Exchange rate
Source: Results from data analysis in SPS
Data analysis results in table 2 above shows that the correlation coefficient between inflation
and exchange rate during the period was -0.402. This coefficient indicates that there is a
moderate negative correlation between inflation and exchange rate. The standardized
coefficient of -0.402 also implies that the negative correlation between the two variables is
not very strong but average.
30
Table 3: Analysis of Variance (ANOVA)
a
ANOVA
Model
Sum of
df
Mean Square
F
Sig.
Squares
Regression
1
769.533
1
769.533
Residual
4003.074
100
40.031
Total
4772.607
101
19.224
.000
a. Dependent Variable: EXCHANGERATE
b. Predictors: (Constant), INFLATION
Source: Results from data analysis in SPSS
Sum of squares measures the variability of data around the mean. The sum of squares of
769.533 is smaller than the residual value of 4,003.074 indicating that the model does not
account for most of the variation in the dependent variable. The movement in exchange rate is
therefore majorly caused by other factors other than inflation volatility.
Table 4: Correlations
INFLATION
INFLATION
EXCHANGE
RATE
Pearson Correlation
Sig. (2-tailed)
N
Pearson Correlation
EXCHANGERATE
1
102
-.402**
Sig. (2-tailed)
N
-.402**
.000
102
1
.000
102
102
Correlation is significant at the 0.01 level (2-tailed).
Source: Results from data analysis in SPSS
The Pearson correlation coefficient between exchange rate movement and inflation volatility
for the research period was -0.402. This coefficient indicates that, there is a moderate negative
correlation between inflation and exchange rate.
31
b
Table 5: Model Summary
Model
R
R Square
Adjusted R
Std. Error of the Estimate
Square
1
.402
a
.161
.153
6.32699
Predictors: (Constant), Inflation
Source: Results from data analysis in SPSS
The result in table 5 above shows that the correlation coefficient of determinant also known as
the R square based on a total of 102 observations was 16.1%. R square measures the proportion
of variability in the dependent variable that is explained by the model. The R square of 16.1%
implies that 16.1% of the variation in the exchange rate can be explained by the model. The
remaining 83.9% percent can be attributed to the other variables. This implies that inflation is
not the major cause of changes in exchange rate. Other factors largely influence the movement
in exchange rate.
4.3
Summary and Interpretation of Findings
The data for both variables for the period of study was collected and input into the SPSS
computer package for analysis. Result from descriptive analysis indicates that fluctuation in
inflation during the period was high with a standard deviation of 7.7% as compared to
movement in exchange rate which had a standard deviation of 6.9%.
The result for correlation and regression analysis shows that there is a moderate negative
correlation between inflation volatility and exchange rate movement with a Pearson
correlation coefficient of -0.402%. The findings also indicate that movement in inflation
accounts for about 16.1% of the movement in exchange rate. This therefore implies that
inflation is not the only factor influencing movement in exchange rate, other factors seem to
contribute largely to the movement in exchange rate.
32
The findings of this research tend to agree with the findings of other studies carried elsewhere
about causes of exchange rate movement. A review of literature on exchange rate as
discussed earlier revealed that the causes of exchange rate fluctuation are complex, dynamic
and intertwined. In line with the findings of this study, Inflation has been shown in most of
the studies as having a negative correlation and effect on exchange rate. Moreover, like this
study, the other studies also conclude that inflation is not the sole factor which influences
movement in exchange rate.
For instance, Karim and Klau (2003) established that there was a negative relationship
between inflation and the real exchange rates in most countries of Asia and Latin America.
Similarly, Danjuma (2013) also found that exchange rate and inflation had a negative relation
in Nigeria and an increase in inflation lead to depreciation in the exchange rate of the Naira.
Moreover, Ndung’u (2000) research on monetary and exchange rate policy in Kenya shows
that monetary shocks drive real exchange rate movements. This implies that when money
supply or domestic credit growth is excessively out of line with the growth in economic
activity, it feeds into the real exchange rate movements. In addition real income and inflation
are negatively associated with the nominal exchange rate movements.
33
CHAPTER FIVE
SUMMARY, CONCLUSIONS AND RECOMMENDATIONS
5.1
Summary
Exchange rate is one of the most important macroeconomic variables in both the developing
and developed countries. It affects the exports and imports of a country thereby determining
the balance of trade of a country. Prior to the 1970’s vast majority of countries had fixed
exchange rate regimes. In the 1970’s, most countries decided to abandon the fixed exchange
rate system in favor of a floating or market-determined exchange rate. This has led to constant
fluctuation in exchange rate in response to changes in the underlying macro economical
variables. The most common theories of exchange rate are the fisher’s effect and the PPP
theories which have hypothesized that interest rate and inflation have a negative effect on
inflation respectively.
The aim of this study was to establish the relationship between inflation volatility and
exchange rate fluctuation in Kenya. The study relied on the hypothesis of purchasing power
parity theory of existence of a negative relationship between inflation and exchange rate
movement. The research covered a period of nine years from January 2005 to December
2013.
The study was inspired by the fact that despite the hypothesis by PPP theory and the general
observation in the market where exchange rate tends to follow inflation though in an opposite
direction, very few studies had been conducted both in general and specific to Kenya to
establish whether empirically there is any relation between the two variables. Moreover, the
few studies done had varied conclusions on the relationship between these two variables.
This being an explanatory type of research, it relied on secondary data obtained from Central
Bank of Kenya and the Kenya National Bureau of Statistics. The data collected was entered
into excel and SPSS computer packages for analysis.
34
5.2
Conclusion
As stated earlier, exchange rate is one of the most important macroeconomic variables in a
country. Exchange rate affects the prices of both imports and exports thereby determining the
direction of international trade. It is therefore very important for the government policy
makers, the trades and the general public to understand the factors that affect the movement in
exchange rate. This will enable them to make appropriate decisions during exchange rate
fluctuations.
The aim of this study was to establish the relationship between inflation volatility and
exchange rate fluctuation in Kenya. The study covered a period of nine years from January
2005 up to December 2014. The results obtained from data analysis indicate that inflation had
a moderate negative effect on exchange rate during the period of study with a Pearson
correlation coefficient of -0.402%. The findings also indicate that inflation is not the major
factor influencing movement in exchange rate, other factors contribute largely to movement
in exchange rate at 83.1%.
The result of this study tends to confirm the proposition of the PPP theory that inflation has a
negative relationship with exchange rate. The study also agrees with the findings of other
previous studies which conclude that although the causes of exchange rate fluctuation are
dynamic and complex.
Since fluctuation in exchange rate can be caused by many factors, it is therefore important for
policy makers to understand all the factors which contribute to movement in exchange rate in
a country. This will enable them to apply appropriate measures to counter the fluctuation and
stabilize the exchange rate.
35
5.3
Recommendations
This research was conducted with the aim of establishing the effect of inflation on exchange
rate fluctuation in Kenya. The results obtained from data analysis indicate that there is a
negative relationship between these two variables. It is therefore recommended that the
government should put in place appropriate policies and strategies that will ensure the
maintenance of a stable inflation rate as this has been found to be an important factor
influencing exchange rate movement.
In line with the above, the government should direct its expenditure to the key productive
sectors of the economy such as agriculture and manufacturing which will go a long way in
increasing the production of goods and services thereby stabilizing the prices of commodities
in the domestic market. Government should also adjust its monetary policy accordingly in
order to avoid increase of money supply to the economy which increases the individual
incomes and eventually leads to inflation. This will go a long way in stabilizing inflation and
consequently contribute to having a stable exchange rate.
In line with the findings of this study, it is also recommended that although volatility in
inflation has been established to have a negative relationship with exchange rate movement, it
is not the sole factor causing movement in exchange rate. It is therefore suggested that policymakers should employ inflation stabilization as a measure to compliment other macroeconomic policies to stabilize the fluctuation of exchange rate.
The research therefore recommends that the government should set put in place appropriate
measures to stabilize inflation. Policy makers should also keenly monitor the other factors
influencing movement in exchange rate such as market interest rates and income levels in
order to stabilize exchange rate. Finally, the government can also directly intervene to
stabilize the exchange rates by increasing or reducing the supply of the foreign currency.
36
5.4
Limitations of the Study
The research utilized data for exchange rate between the Kenya Shilling and the US dollar.
The results obtained from this study are therefore true for one foreign currency only i.e. US
Dollar. Although the US dollar is the main currency used in international trade in Kenya,
other currencies including the Euro, the sterling pound, the Yen, the Rand as well as the
Tanzania and Uganda shillings among others are also used. The exchange rate variation in
response to movement in inflation with respect to these other foreign currencies may be
different and give different results.
Movements in exchange rate were seen to be high especially for the years of National
Elections in Kenya. It is then possible that to a greater extent, movement in exchange rate was
due to political reasons rather than inflation. Similarly, there was a high fluctuation in
exchange rate between June 2011 and December 2011 which was far beyond the normal. Due
to time and resource limitations, the research accounted for this by ignoring the figures for
this period during data analysis, it was not therefore clear what caused the fluctuation in
exchange rate.
Due to lack of adequate information and limited time, the research was also one sided in the
sense that it only considered the volatility in inflation in Kenya and not in both Kenya and
USA. The assumption taken by the research that inflation in the USA was static during the
period of research is not true and this could have affected the results.
Finally, as discovered during empirical literature review, the causes of movement in exchange
rate and inflation are intertwined. Movement in inflation has been identified as a reason for
movement in exchange rate and similarly, movement in exchange rate has also been found to
be leading to inflation in some countries. A more advanced data analysis technique than linear
regression analysis therefore needed to be applied in analyzing the effect of the variables on
each other.
37
5.5
Suggestions for Future Studies
The research study only relied on the exchange rate of Kenya Shilling and the US dollar. The
results from this research are therefore only true for the US dollar and may not be true for all
foreign currencies. A comprehensive research on the same variables involving all major
currencies used in international trade in Kenya can be conducted in order to get result that is
all inclusive.
As established during empirical literature review, the causes of fluctuation in exchange rate
are dynamic, complex and intertwined. A more advanced research can be conducted
involving all the factors identified as causing fluctuation in exchange rate such as interest
rate, inflation, government controls, income levels and market expectations can be
undertaken. The research can then identify the extent to which each factor contributes to
movement in exchange rate.
3-The data collected during this study were analyzed using simple linear regression
techniques. However, as explained before, causes of movement in exchange rate and inflation
are intertwined. It is therefore possible that changes in inflation may lead to changes in
exchange rate and similarly, changes in exchange rate can lead to movement in inflation.
Research on the same variables can be done but the data analyzed using an advanced
statistical technique to identify the effect of each variable on each other.
38
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42
APPENDIX 1
Month and Year
Monthly inflation Rates
Jan-2005
Feb-2005
March-2005
April-2005
May-2005
June-2005
July-2005
Aug-2005
Sept-2005
Oct-2005
Nov-2005
Dec-2005
Jan-2006
Feb-2006
March-2006
April-2006
May-2006
June-2006
July-2006
Aug-2006
Sept-2006
Oct-2006
Nov-2006
Dec-2006
Jan-2007
Feb-2007
March-2007
April-2007
May-2007
June-2007
July-2007
Aug-2007
Sept-2007
Oct-2007
Nov-2007
Dec-2007
Jan-2008
Feb-2008
March-2008
April-2008
May-2008
14.9
13.9
14.1
16
14.8
11.9
11.8
6.9
4.3
3.7
6.0
7.6
15.4
18.9
19.1
14.9
13.1
10.9
10.1
11.5
13.8
15.7
14.6
15.6
9.7
6.8
5.9
5.7
6.3
11.1
13.6
12.4
11.7
10.6
11.8
12
18.2
19.1
21.8
26.6
31.5
43
Monthly exchange Rates
77.93
76.94
74.8
76.15
76.4
76.68
76.23
75.81
74.1
73.72
74.73
73.12
72.21
71.8
72.28
71.3
71.76
73.41
73.66
72.87
72.87
72.29
71.13
69.63
69.88
69.62
69.29
68.58
67.19
66.57
67.07
66.97
67.02
66.85
65.49
63.42
68.08
70.47
64.81
62.34
61.9
June-2008
July-2008
Aug-2008
Sept-2008
Oct-2008
Nov-2008
Dec-2008
Jan-2009
Feb-2009
March-2009
April-2009
May-2009
June-2009
July-2009
Aug-2009
Sept-2009
Oct-2009
Nov-2009
Dec-2009
Jan-2010
Feb-2010
March-2010
April-2010
May-2010
June-2010
July-2010
Aug-2010
Sept-2010
Oct-2010
Nov-2010
Dec-2010
Jan-2011
Feb-2011
March-2011
April-2011
May-2011
June-2011
July-2011
Aug-2011
Sept-2011
Oct-2011
Nov-2011
Dec-2011
Jan-2012
29.3
26.5
27.6
28.2
28.4
29.4
27.7
21.9
25.1
25.8
26.1
19.5
17.8
17.8
18.4
17.9
6.6
5.0
5.3
4.7
5.2
4.0
3.7
3.9
3.2
3.2
3.2
3.21
3.09
3.84
4.51
5.42
6.54
9.19
12.05
12.95
14.49
15.53
16.67
17.32
18.91
19.72
18.93
18.31
44
63.78
66.7
67.69
71.3
76.66
78.18
78.04
79.0
79.53
80.26
79.63
77.86
77.85
76.75
76.37
75.6
75.24
74.74
75.43
75.79
76.73
76.95
77.25
78.54
81.02
81.43
80.44
80.91
80.71
80.46
80.57
80.02
81.47
84.21
83.89
85.43
89.05
89.9
92.79
96.36
101.27
93.68
86.67
86.34
Feb-2012
March-2012
April-2012
May-2012
June-2012
July-2012
Aug-2012
Sept-2012
Oct-2012
Nov-2012
Dec-2012
Jan-2013
Feb-2013
March-2013
April-2013
May-2013
June-2013
July-2013
Aug-2013
Sept-2013
Oct-2013
Nov-2013
Dec-2013
16.69
15.61
13.06
12.22
10.05
7.74
6.09
5.32
4.14
3.25
3.2
3.67
4.45
4.11
4.14
4.05
4.91
6.02
6.67
8.29
7.76
7.36
7.15
Data Source:
Inflation: KNBS website.
Exchange rates: central bank of Kenya website
45
83.18
82.9
83.19
84.46
84.79
84.14
84.08
84.61
85.11
85.63
86.0
86.9
87.45
85.82
84.19
84.15
85.49
86.85
87.48
87.41
85.31
86.1
86.31