EFFECT OF MACROECONOMIC VARIABLES ON EXCHANGE RATE VOLATILITY IN KENYA

Abstract

Foreign direct investment, government expenditure, public debt, inflation rate, interest rates, and money supply are essential macroeconomic variables that can alter currency volatility and its impact on the Kenyan economy. The exchange rate of the Kenyan shilling has exhibited significant volatility against major currencies such as the US dollar. In 2022, the KES depreciated by an average of 0.6% monthly. This trend intensified in early 2023, with average monthly depreciation rates reaching 4%, and some months witnessing increases of up to 6%. By October 2023, the exchange rate reached KES 148.4 per US dollar, up from KES 120.8 in early 2022, marking a 13% depreciation in 2023. In January and February 2024, the KES continued to weaken, exceeding KES 160 and 163.98 per US dollar, respectively. This sharp fluctuation in the Kenyan shilling highlights concerns about currency stability. The objective of this study was to examine the effect of foreign direct investment, government expenditure, public debt, inflation rates, interest rates, and money supply on exchange rate volatility in Kenya. The study was informed by the Purchasing Power Parity Theory, the General Equilibrium Theory of Exchange Rate Determination, the International Fisher Effect theory, and the Interest Rate Parity theory. The study used an explanatory research design, analysing annual secondary data from 1971 to 2024. Data was collected using a structured review matrix and tested for stationarity and cointegration before analysis using descriptive statistics and the ARDL model. Descriptive statistics results showed that the average FDI, government expenditure, and public debt were 0.71, 15.68% and 47.60% respectively. Interest rates, inflation rate, and money supply growth averaged 6.20%, 11.31% and 34.77%, respectively. Inferential results revealed that in the long run, a unit increase in foreign direct investment and government expenditure reduced exchange rate volatility by 36.4% and 341.5%, respectively, while inflation and money supply increased it by 55.2% and 239.7%, respectively. Short-run results showed that a 1% increase in FDI, money supply, and inflation rate increased volatility by 18.31%, 19.26%, and 111.83%, respectively, while government spending and public debt reduced volatility by 90.65% and 42.18%, respectively. To reduce or stabilise exchange rate volatility, the study recommended a combination of monetary policy interventions to policymakers. These included foreign exchange operations, interest rate adjustments, hedging strategies, and export diversification. Additionally, the central bank is advised to regulate the growth of the money supply to prevent excessive inflation and currency depreciation, which could exacerbate exchange rate fluctuations.