The Causal Relationship between Interest Rates and Foreign Exchange Rates in Kenya

Abstract

The objective of this research was to investigate the causal relationship between interest rates and foreign exchange rates in Kenya. The data sources were limited to the nominal value of exchange rate represented by the Kenya Shilling price of one US dollar and aggregate interest rate represented by the Treasury bill yield over a 3-month period. The data set consisted of monthly observations of the nominal value of the daily closing exchange rate between January 1993 and June 2006. The monthly closing Treasury bill rates over the same period were used. Testing causal relations between interest rates and foreign exchange rates were based on comparing the results of Granger causality test of Granger (1969) based on error correction modelling (ECM) technique. The series were tested for stationarity, co-integration, autocorrelation, and heteroscedasticity. The main findings were that foreign exchange rates do not Granger-cause interest rates. Moreover, since there was a significant error correction term, it was concluded that causality between interest rates and foreign exchange rates in Kenya is attributable to external factors other than the variables in the model. It was therefore established that interest rates causes foreign exchange. These findings support previous empirical studies by Furman and Stiglitz (1998), Goldfajn and Gupta (1999), Cho and West (2001) that interest rates Granger cause exchange rates.

Keywords: Augmented Dickey-Fuller Test, Autoregressive Distributed Lag, Covered Interest Parity, Dickey Fuller Test, Error Correction Model, Error Correction Terms, Expectations Theory, Fisher Effect, Final Prediction Error, Gross Domestic Product, Uncovered Interest Parity, Vector Auto-regression, Vector Error Correction Model