The Short term and long-term impact of interest rates on exchange rates in Kenya

Abstract

The interaction between interest rates and exchange rates forms an important component of macroeconomic stability and monetary policy in developing economies. This research focuses on the developing nation of Kenya, examining the extent to which changes in interest rates influence fluctuations in the exchange rate of the Kenyan Shilling against the US Dollar. Specifically, the study evaluates the causal relationships between these variables while considering key moderating factors such as inflation and GDP. By employing advanced econometric models, including the Autoregressive Distributed Lag (ARDL) and the Error Correction (ECM) models, the research analyzes historical time-series data spanning multiple economic cycles from 2019 to 2024. The study seeks to address questions surrounding the effectiveness of interest rate adjustments as a tool for exchange rate stabilization and explores whether this understanding of the intervention between interest rates and exchange rates can be used to derive the intended outcome. The findings of the paper revealed that in the short-term the correlation coefficient between interest and exchange rates stands as -0.0008715. This indicated a weak negative relationship between the variables in the short-term. This means that in the short-term the impact of interest rates on exchange rates is very small and negative. In the long-run however the ECM model found that the correlation coefficient between interest rates and exchange rate was 0.7033075. This indicates that in the long-run, interest rates tend to have a positive impact on exchange rates which is much more significant than the impact in the short-term.