The Relationship Between Money Supply and Real Effective Exchange Rate Fluctuations in Kenya

Abstract

Exchange rates play an important role in economic growth especially through foreign trade. Exchange rates in Kenya have been experiencing fluctuations since the transition of the fixed exchange rate regime of the 1960s to the crawling peg of the 1970s to 1980s and lately the floating exchange rate of the 1990s to date. The exchange rate has oscillated between Kshs. 7.142 in 1960s to Kshs. 102.35 per unit US dollar in 2015. The magnitude of exchange rate fluctuations in most developing economies has attracted the interest of many scholars including economists and policy makers. These scholars have however differed on the determinants of real effective exchange rate fluctuations and their respective levels of significance. The purpose of this study therefore was to examine the relationship between money supply and real effective exchange rate fluctuations in Kenya. External debt, trade balance and inflation rate were used as the intervening variables. The study was anchored on the balance of payments theory of exchange rate determination. The study used annual time series data for the period (1972-2015). The study used correlational study design and it employed the stationarity tests, cointegration and ECM. The study concluded that there exists a positive significant relationship between money supply, trade balance, inflation rate and real effective exchange rate fluctuations in Kenya. An increase in money supply also leads to depreciation in the Kenyan shilling same to an increasing inflation rate. An increasing debt burden depreciates the Kenyan shilling. These results are in conformity with the balance of payments theory of exchange rate determination. The study recommends that policy makers should formulate sound credit control policies to control money supply in the economy.

Keywords: Money supply, exchange rate, trade balance, external debt, inflation rate, Kenya

DOI: 10.7176/JESD/10-12-14

Publication date:June 30^th 2019