Granger Causality and Error Correction Models in Economics: A Case study of Kenyan Market

Abstract

The U.S. Dollar exchange rate and the interbank lending rate in Kenya are analyzed. An Error Correction Model (ECM) is used to establish if there exists any short term relationship between the lending and the exchange rates. A linear ECM is fitted and there is evidence that a short-term relationship exists between these two rates. A high threshold value exists at the second lag, an indication of simple smoothing in the data. The residual deviance is greater than the degrees of freedom confirming that the model perfectly fit to the data. This is supported by the high R2 value of 0.9308. A Granger Causality model is also built to demonstrate all the long term relationships. Contrary to hypothesis of the study, only the exchange rate granger caused interbank lending rate. This can be explained by the instability in the exchange market. It can be attributed to the economic crisis experienced in recent years; that is, an unexpected and sudden attainment of economic stability. The study concludes that Error Correction Models and Granger Causality models are significantly appropriate in analysing time series. It is suggested that a close track of exchange rates may lead to prediction of interbank lending rate movements. Further research is recommended on the factors influencing exchange rate movements and analysis of tail clustering.Keywords: Granger Causality, Error Correction Model, Economics