Effect of Inflation and Interest Rates on Foreign Exchange Rates in Kenya

Abstract

Exchange rates, inflation rates and rates of interest are indispensable variables of macroeconomic, which can change the growth pattern and direction of economic stability and development in a country. Over the years, the Kenyan Shilling has recorded significant volatility against the major currencies especially the Sterling Pound and the US Dollars. For instance, in July 2015, the Kenyan shilling depreciated at rate of 11.16% and 14.45% to the GBP and USD respectively. This study examined the effect of inflation and interest rates on foreign exchange rates in Kenya. A descriptive research design was employed to answer the research question. To attain the aim of the research, secondary data was entirely used. The research applied quarterly data for a period of 10 years from 2007 to 2016. The study also carried out tests on normality autocorrelation and multicollinearity. Analysis of data was done by the use of descriptive statistics, the multiple regression analysis and the Pearson correlation. The results found that the consumer price index significantly and positively affects foreign exchange rates while foreign direct investment significantly and negatively affects foreign exchange rates. Conversely, the study found that interest rates (IR) and the gross domestic product (GDP) had an insignificant and negative relationship with foreign exchange rates while money supply (M3) has an insignificant positive effect on foreign exchange rates. The study findings concluded that inflation has a direct effect on exchange rates and that forex rates in Kenya are inversely affected by foreign direct investments inflows. The study recommended that the central bank of Kenya and the Kenyan government should use the available monetary policy tools to control a rise in inflation rates and consumer prices. The study also recommended that the Kenyan investment authority should come up with policies that will market the country and attract more foreign direct investment inflows.