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A Monetary Approach to Exchange Rate Dynamics in Low-Income Countries: Evidence from Kenya

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  • Nandwa, Boaz
  • Mohan, Ramesh

Abstract

The flexible price monetary model assumes that both the purchasing power parity (PPP) and uncovered interest parity (UIP) hold continuously. In addition, the model posits that money market equilibrium exists, which helps to determine the exchange rate. This paper explores exchange rate determination in low-income economies by applying a monetary model to Kenya to examine the exchange rate dynamics in a post-float exchange rate regime. We apply a multivariate cointegration and error correction model (ECM) to investigate whether the long-run exchange rate equilibrium and the rate of adjustment to the long-run equilibrium hold, respectively. Finally, we evaluate the relative performance of ECM versus a random walk framework in the out-of-sample forecasting. We find that the random walk performs better than the restricted model.

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Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 5581.

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Date of creation: 02 Nov 2007
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Handle: RePEc:pra:mprapa:5581

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Keywords: Exchange rate; volatility; regime changes; Kenyan Shilling;

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  1. Gonzalo, Jesus, 1994. "Five alternative methods of estimating long-run equilibrium relationships," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 203-233.
  2. Hendry, David F & Doornik, Jurgen A, 1994. "Modelling Linear Dynamic Econometric Systems," Scottish Journal of Political Economy, Scottish Economic Society, vol. 41(1), pages 1-33, February.
  3. Meese, Richard A, 1986. "Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 345-73, April.
  4. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  5. John Y. Campbell & Robert J. Shiller, 1986. "Cointegration and Tests of Present Value Models," NBER Working Papers 1885, National Bureau of Economic Research, Inc.
  6. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
  7. Francis X. Diebold & Robert S. Mariano, 1994. "Comparing Predictive Accuracy," NBER Technical Working Papers 0169, National Bureau of Economic Research, Inc.
  8. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November.
  9. Engle, Robert F, 1982. "Autoregressive Conditional Heteroscedasticity with Estimates of the Variance of United Kingdom Inflation," Econometrica, Econometric Society, vol. 50(4), pages 987-1007, July.
  10. MacDonald, Ronald & Taylor, Mark P., 1989. "Foreign exchange market efficiency and cointegration : Some evidence from the recent float," Economics Letters, Elsevier, vol. 29(1), pages 63-68.
  11. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
  12. Alwyn Young, 1992. "A Tale of Two Cities: Factor Accumulation and Technical Change in Hong Kong and Singapore," NBER Chapters, in: NBER Macroeconomics Annual 1992, Volume 7, pages 13-64 National Bureau of Economic Research, Inc.
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