An Empirical Investigation of Exchange Rate Determination in Kenya: Does Current Account Imbalance Play a Role?

The paper investigates exchange rate determination in Kenya using vector error correction model approach to uncover the long run relationships. The empirical results show that current account balance has a role to play in the determination of the exchange rate. A rise, which denotes an improvement in the current account balance, is associated with an appreciation of the exchange rate. Additionally, higher domestic interest rates relative to foreign interest rates, as well as a rise in foreign price have an appreciating effect on the exchange rate while domestic price increase is associated with depreciation of the domestic currency. The results further show that although there are feedback effects between the exchange rate and the domestic price level, the feedback effect from exchange rate to the domestic price is not significant once the effect of current account balance is taken into consideration. In terms of policy, strategies aimed at addressing external imbalances as reflected in the current account balance are important in stabilizing the exchange rate in the long run. These should be complemented with pursuit of interest rate path that is consistent with the desired exchange rate outcomes.