The Determinants of the Kenya Shilling-united States Dollar Exchange Rate

Abstract

There are many determinants of the KES-USD exchange rate. This study took a descriptive stance to look at interest rates differential and interest rate differentials and how they affect the exchange rate. For the period from august 2008 to July 2022. Purchasing power parity and international fisher effect are the theories on which the study was based on. STATA was the software that was used to analyze the data. The variables were tested for stationarity, cointergration, autocorrelation, normality, and heteroscedasticity and multi collinearity. Exchange rates and interest differentials were not found to be stationary and as a result the 1st difference was calculated and used for analysis. There was no evidence of autocorrelation and multi-collinearity. Cointergration tests showed that there’s a long run relationship, interest rate differential is significant at 5% while inflation differential is not. According to the STATA output, a significant P value of zero indicated existence of heteroscedasticity problem which was corrected using the robust command before analysis of the data. Inflation differential was found to have a positive but weak correlation with exchange rate with a correlation of 0.0378. Interest differential however has a stronger but negative correlation of -0.2830 with exchange rates. A correlation of 0.10234 is positive but weaker for the correlation between inflation differential and interest differentials. After correction the error term to normality using the robust command, the following output was obtained for the regression analysis. The null hypothesis of the F test is that R²= 0 suggesting that the model has no explanatory variable while the alternative hypothesis is that R² ≠0 suggesting that the model has explanatory power. With a P value of the F test of 0.3683, the model is not significant at the 10%, 5% or 1% significance levels. With an R² value of 0.0088, our model explains only about 0.8% of the exchange rate by the interest rate differential and inflation differential. The p tests for the independent variables are all statistically insignificant. The p test is significant at the 5% significance level with a p value of the t test of 0.015 for the constant. Coefficient of 0.013848 and -0.0498889 for inflation differential and interest rate differential both suggest that exchange rates vary positively with inflation differential and negatively with interest rate differential. The study found that both the purchasing power parity and international fisher effect were violated for the KES-USD exchange rate in Kenya.