Discussion Paper No. 108 of 2010 on Equilibrium Real Exchange Rates and Real Misalignment in Kenya: A Fundamental Equilibrium Approach

Abstract

With the liberalization of exchange rate in most countries, policy makers have to contend with erratic movements in exchange rates in the short-run, causing exchange rate misalignments in the long run. Exchange rate misalignments have several adverse implications including distorting resource allocation between production sectors, distorting patterns of trade, and distorting debt repayment schedules for indebted countries, among others. When exchange rate movements become erratic, monetary authorities intervene in the exchange rate markets to correct any misalignments. Interventions are supposed to be based on some indicator that the observed exchange rates are either over-appreciated or over-depreciated, hence the need for an intervention. Without this knowledge, it is possible that wrong interventions may be carried out, interventions may be carried out when they are not necessary, or interventions may not be done at all when they are necessary. This study estimates the equilibrium exchange rate in Kenya using the fundamental equilibrium approach. The results show that there were three main episodes of misalignment; in late 2002 to early 2003, mid 2004, and mid 2005. In general, the study finds that real exchange rate misalignments are mean-reverting in the long run, and therefore should not warrant policy intervention.