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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.

Suggested Citation

  • Nandwa, Boaz & Mohan, Ramesh, 2007. "A Monetary Approach to Exchange Rate Dynamics in Low-Income Countries: Evidence from Kenya," MPRA Paper 5581, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:5581
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    File URL: https://mpra.ub.uni-muenchen.de/5581/1/MPRA_paper_5581.pdf
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    References listed on IDEAS

    as
    1. 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.
    2. Diebold, Francis X & Mariano, Roberto S, 2002. "Comparing Predictive Accuracy," Journal of Business & Economic Statistics, American Statistical Association, vol. 20(1), pages 134-144, January.
    3. 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.
    4. McNown, Robert & Wallace, Myles, 1989. "Co-integration tests for long run equilibrium in the monetary exchange rate model," Economics Letters, Elsevier, vol. 31(3), pages 263-267, December.
    5. 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.
    6. 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 345-373, April.
    7. 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.
    8. Campbell, John Y & Shiller, Robert J, 1987. "Cointegration and Tests of Present Value Models," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1062-1088, October.
    9. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    10. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-1580, November.
    11. Gonzalo, Jesus, 1994. "Five alternative methods of estimating long-run equilibrium relationships," Journal of Econometrics, Elsevier, vol. 60(1-2), pages 203-233.
    12. Johansen, Soren, 1988. "Statistical analysis of cointegration vectors," Journal of Economic Dynamics and Control, Elsevier, vol. 12(2-3), pages 231-254.
    13. 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.
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    More about this item

    Keywords

    Exchange rate; volatility; regime changes; Kenyan Shilling;

    JEL classification:

    • C32 - Mathematical and Quantitative Methods - - Multiple or Simultaneous Equation Models; Multiple Variables - - - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models; Diffusion Processes; State Space Models
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods

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