The effect of interest rate differential on the foreign exchange rate in east African Forex market
The study sought to understand the effect of interest rate differential on the foreign exchange rate in the East African forex market. The development of literature was guided by Interest Rate Parity (IPR) Theory and the Purchasing Power Parity (PPP) Theory. The descriptive research design was used in this study. Kenya National Bureau of Statistics (KBA), Central Bank of Kenya, Bank of Tanzania, Bank of Uganda and the IMF e-library were the sources of information in the pursuit to establish the effect of interest rate differential on the foreign exchange rate in East Africa. The study used inflation rates in percentage, interest rates in percentage, consumer price indices, monthly inter-bank rates and monthly current account deficit/surplus from 2009-2014. Multiple linear regression was used to model the relationship between the three explanatory variables and a response variable was used by fitting a linear equation to observed data. Multiple regression analysis was also used to assess whether correlation exists. The study found that more than 51% of the variations in the dependent variables, real interest rate differential, inflation rate and current account deficit/surplus was attributed to other unknown factors. The main predictor variable of our study in the three countries (Kenya, Uganda and Tanzania), real interest rate differential, accounted for less than 10% of the variation in the dependent variable, real exchange rate (RER). As a result the researcher could not be able to find any relationship between real interest rate differential and the real exchange rate and whether the of theories purchasing power parity (PPP) and interest rate parity (IRP) hold for this study. The study further suggested that more research be carried out to bring forth more knowledge to the pool of literature on relationship between real interest rate differential and real exchange rate.