Discussion Paper No. 01 of 2000 on the Exchange Rate and the Interest Rate Differential in Kenya: A Monetary and Fiscal Policy Dilemma

Abstract

The paper analyses the relationship between the real exchange rate and the real interest rate differential on one hand and the implications they have on portfolio capital flows on the other. It shows that the nominal exchange rate deviates from the perceived long-run equilibrium level determined by the purchasing power parity relationship, and these deviations are governed by the interest rate differential The deviations from purchasing power pariry are absorbed by the real interest rate differential in an error correction formulation. Since the high-frequency data used is likely to be noisy, the model is re-estimated in a technique that uses time-varying parameters (the Kalman filter) far comparison. The Kalman filter uses all the available information in a manner related to Bayesian learning and can be considered the empirical counterpart to rational expectations. The results are not radicalfy different. This allows us to move further and interpret the results. It is argued that the interest rate differential will widen as the real exchange rate appreciates, and this triggers capital to flow in. Also, domestic inflation will rise as the real exchange rate depreciates, and the influence of foreign inflation will decrease as the exchange rate appreciates. The policy lessons that emanate from these results relate to interest rate structure and exchange rate management. One of the aspects of policy dilemma argued in the paper is that the real interest rate differential and the exchange rate absorb shocks from each other...