Effect of Macro Economic Variables on Foreign Exchange Rate in Kenya

Abstract

Foreign exchange rate is a major economic growth and development pillar of any economy. Foreign exchange market refers to the intercontinental market, where currencies are merchandised virtually around the globe. Increase in interest rate means devaluation of local currency due to low investment level associated with high cost of acquiring finance. Low investment level means low production of goods and services in local country thus low inflow of foreign currency due to low export level causing high demand level for foreign exchange rate. The main objective of this study was to determine the effect of macro-economic variables on foreign exchange rates in Kenya. Specifically, the study sought to investigate the effect of inflation, political instability, broad money supply, interest rate and GDP growth rate covering a period of 10 years from January 2010 to December 2019.Descriptive analysis was used to determine mean, maximum, minimum and standard deviation of the variables to know the general characteristics of the variables over the period of study. Data analysis was performed using SPSS version 25.0 and STATA version 15.0 software. Several diagnostic tests were employed on the model such as tolerance and variance inflation factor to determine if the independent variable have strong correlation where multicollinearity, was absence. Normality test was employed using a Histogram and result concluded present of normal distribution. Heteroskedasticity test was done using white test where result concluded no heteroskedasticity in the model. Regression analysis was done and the results established that 14.7% variance in exchange rate could be accounted for in the model by exchange rate using the Adjusted R2. From the regression the result shows a negative significant relationship between inflation and exchange rate, positive significant relationship between interest rates and GDP growth rate and exchange rate. The study found that interest rate was the most important macroeconomic variable that determine the level of foreign investment and hence exchange rate it had highest determining power over other variables by 61.81%. However, the findings did not find any significant relationship between broad money supply and exchange rate. Political stability index was also found to be a significant factor influencing exchange rate. The study concluded that a unit increase in inflation lead to significant decrease of 45.7 percent in exchange rate. Also, a unit change in interest rate results to significant change of 61.8% in exchange rate and finally a unit change in GBD result to 43.9% increase in exchange rate. From the study it is recommended the government to have close monitoring of macro-economic factor since they are determinant of foreign exchange rate through monetary and fiscal policies.