Exchange Rate Fluctuations and Macroeconomic Stability in Kenya: A SVAR Model

This study examines the dynamic relationship between exchange rate fluctuations and macroeconomic stability in Kenya over the period 1980–2024, a period characterized by persistent currency depreciation and fragile macroeconomic conditions. Anchored in Purchasing Power Parity (PPP) theory and supported by the Mundell-Fleming Model and New Keynesian Theory, the study adopts a pragmatist philosophy and employs a quantitative, descriptive-correlational research design. Annual time-series data on six macroeconomic variables — bilateral exchange rate (BIER), inflation rate (INFLR), GDP growth rate (GDPGR), net balance of payments (NBOP), interest rate (IR), and fiscal deficit (FD) — were analysed using the Structural Vector Autoregressive (SVAR) model, complemented by Granger causality tests, impulse response functions (IRFs), and forecast error variance decomposition (FEVD). Trend analysis yielded a coefficient of 2.707 (p = 0.000), confirming a statistically significant and sustained depreciation of the Kenyan shilling. Granger causality results established that exchange rate fluctuations significantly precede fiscal deficit changes (p = 0.0225), while fiscal deficit strongly Granger-causes interest rates (p = 0.0003) and GDP growth (p = 0.0456). IRF analysis demonstrated that a one-standard deviation exchange rate shock triggers an immediate rise in inflation, a short-term contraction in GDP growth, worsening of the balance of payments, and a tightening monetary policy response. Variance decomposition confirmed that while most macroeconomic variables are predominantly driven by their own past innovations, exchange rate shocks account for approximately 6.8% of inflation variance and up to 5.5% of fiscal deficit variance in the medium term. These findings underscore the centrality of exchange rate stability to Kenya's macroeconomic framework and call for coordinated fiscal-monetary policy responses, integration of exchange rate signals into inflation-targeting frameworks, and alignment of macro policy with the objectives of Kenya Vision 2030.