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Question:

Discuss about the misalignment of the Exchange Rate of Kenya.
 
 

Answer:

Introduction

In recent times, an understanding of the real exchange rate (RER) is important because it helps to understand the reason for uneven development in the economy of the country. It can be seen that due to prolonged misalignment of exchange rate in Latin America and Africa the growth rate have been slow. On the other hand, in Asia due to judicious macroeconomics, exchange rate and trade it has been able to maintain growth.

Area of study

The misalignment in the stable exchange rates and adjustable systems indicates that the policies are fundamentally poor. This poor policy prevents the exchange rate fundamental adjustments though the fundamental of the economy has changed. In case of floating exchange rate the main reason for the misalignments are the speculations that moves the exchange rate more than in compared to change in the economic fundamentals (Alagidede & Ibrahim, 2016). The growth of the economy is influenced by the Real Exchange rate through different ways. The exchange rate influences the foreign and domestic investment. This influences the capital accumulation of the economy as a result effecting the overall economic growth. The area of the study in the research is to assess the impact of currency misalignment in economic growth of Kenya.

 

Background of the study

In the period of 1966-1992 during the period of fixed exchange rate regime the developing country like Kenya has to frequently devalue the currency so that the negative effect that RER volatility has on the economy could be reduced. In 1993, the introduction of floating exchange rate was an important step to eliminate the RER volatility. However, there is no evidence to suggest that the liberalization of exchange rate markets have achieved its objectives (Ali, 2015).

In the developing countries like Kenya, the policy decisions for exchange rates are very sensitive and controversial. The change in exchange rate policy requires structural transformation and domestic adjustment. The change in policy has short-term effect on price and demand and this is regarded as damaging the economy (Karanja, 2016). The role of the RER on the movement of the trade balance is much debated. However, the economists does not persuasively answers whether a country should allows its currencies to be floating. In the developing countries, the decision regarding the foreign exchange policy is regarded as one of the most important policy decision that affects the economic growth.

Statement of the problem

The exchange rate is referred to as the key macroeconomic variable. It plays an important role in the transaction between the open economies. The relationship between the theoretical concept and the empirical application of the exchange is not straight forward and simple. There are two theoretical views about the effect of the exchange rate fluctuations on the output. The first view is that if the exchange rate of the domestic currency appreciates then the cost of import will reduce as a result the output will increase (Cheung & Fujii, 2014). The second view is that exchange rate appreciation reduces the price competitiveness of the domestic products internationally. This in effect reduces the accumulated demand of the product hence the output is reduced. This two conflicting views creates an empirical issues. Therefore, an empirical test for growing economies like Kenya is necessary. Many literatures highlight the effect of exchange rate fluctuation on the growth of the economy. However, studies that specifically focuses on the economy of Kenya and the impact that the exchange rate fluctuation have on the economic growth of Kenya is very rare (Nyamweya & Ali, 2016). 

 

Objective of the study

The main objective of the research is to study the misalignment of the exchange rate of Kenya and the effect it has on the economic growth of Kenya. The specific objective of the research are listed below:

  • To review the exchange rate policies and the macro economic performance of the economy;
  • The examination of the effect that the REM has on the economic growth of Kenya;
  • To provide recommended policies based on the study;

Therefor it can be seen that this research has a much wider objectives. This study will help the policymakers to develop appropriate policies so that the situation of economic growth can be improved.

Hypothesis

In this case, the research aims to prove the Hypothesis that the exchange rate misalignment affects the economic performance of Kenya that is measures in terms of Gross domestic product. The null hypothesis in this research is that the economic performance of Kenya is not affected by the fluctuation in the exchange rate.

Literature review

Kenya is a developing country in Africa. The real gross domestic product of Kenya has been $55.1 billion in 2013, $61.4 in 2015 and $63.4 billion in 2016. It can be seen that the economy is constantly and steadily growing.   The economy of the country is mainly dependent on the agriculture and the tourism sector. The country has faced various drought post financial crisis but since the year 2012, the economy of Kenya has made tremendous recovery (Agbeja, 2016).

 


In order to analyze the impact of exchange rate on GDP the three theoretical models have been applied.  The first model is the absorption approach and monetary approach that focuses on the macroeconomics links, identities and not the microeconomic relationship as provided in the approach of elasticity. In this approach it is implied that if the domestic growth exceeds the domestic absorption then only can trade account improve. Therefore it can be seen that devaluation increases the trade balance (Iyke & Odhiambo, 2015).

The second approach is the monetary approach and it regards balance of payment as a monetary phenomenon. In this case, it can be seen that the devaluation in currency causes improvement in the balance of payment by increasing the domestic price and decreasing the supply of real money.

The third approach is the elasticity approach. In this approach, it can be seen that the elasticity is mainly based on the variant of Bickerdike – Robinson Metzler (BRM) condition and the simplified conditions provided in simplified Marshall-Lerner (ML). The BRM provides the necessary conditions related to demand of import, size of import, demand of export and supply elasticity of export that improves the balance of trade of the country. The devaluation of currency effects the relative price of export and import. This will helping promoting growth and reduce the volume of imports (Eregha et al., 2016).

Theoretical framework

The neoclassical growth theory is the basis on which the modelling of the research is conducted. In this model the variables that are used represents the structural policy that are in place. It is provided that the in order to maintain the price stability the rate of inflation is included in the growth model (Pundo, M., & Ganesh, 2014).

 

Research design, methodology and procedure

In this section, the research methodology that is performed in this paper is discussed. The research design is a detailed plan that indicates the method that will be used for analyzing and collecting data. The research design are in line with the research question and objective of the study. The sample is selected for the study from defined population. The data collection should be done from reliable source and analysis should be done of that data (Gouidar & Nouira, 2014).  

Conclusion

The above discussion provides the details concept related to exchange rate and its effect on the economy of Kenya. It can be said that the above paper has provided sufficient information for providing the concept for further research.

 

References

Agbeja, O., Adelakun, O. J., & Udi, E. E. (2016). Empirical Analysis of Counterparty Risk and Exchange Rate Risk Management on the Performance of Deposit Money Banks in Nigeria (2009-2013). Journal of Accounting and Finance, 16(2), 106.

Alagidede, P., & Ibrahim, M. (2016). On the causes and effects of exchange rate volatility on economic growth: evidence from Ghana. Journal of African Business, 1-25.

Ali, A. S. (2015). Effects of Foreign Exchange Rate on Foreign Trade In Financial Performance of the Agricultural Sector in Kenya: A Case Study of Vipingo Sisal Estate. International Journal of Finance and Accounting 4 (6) 1, 19.

Cheung, Y. W., & Fujii, E. (2014). Exchange Rate Misalignment Estimates—Sources Of Differences. International Journal of Finance & Economics, 19(2), 91-121.

Eregha, P., Ndoricimpa, A., Olakojo, S., Nchake, M., Nyang'oro, O., & Togba, E. (2016). Nigeria: Should the Government Float or Devalue the Naira?. African Development Review, 28(3), 247-263.

Gouidar, A., & Nouira, R. (2014). The Impact of Misalignment on FDI in the Developing Countries. International Journal of Economics and Financial Issues, 4(4), 784.

Iyke, B. N., & Odhiambo, N. M. (2015). REAL EXCHANGE MISALIGNMENTS AND ECONOMIC GROWTH IN SUB-SAHARAN AFRICA: PANEL DATA EVIDENCE.

Karanja, A. W. (2016). Strategies to improve performance adopted by social enterprises in Kenya (Doctoral dissertation, University of Nairobi).

Nyamweya, L. N., & Ali, I. (2016). Determinants of Hedging Foreign Currency Risk in Kenya: A Survey of Tea Exporting Companies in Mombasa County. Imperial Journal of Interdisciplinary Research, 2(6).

Pundo, M., & Ganesh, P. P. (2014). The Impact of Real Exchange Rate Misalignment on Economic Growth; Kenyan Evidence.

OR

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