Exchange rate overshooting and its transmission through the monetary policy in Kenya

Abstract

With the floating exchange rate regime that Kenya is currently under, it was suspected at the beginning of this study, that the exchange rate channel of monetary policy transmission mechanism is effective in Kenya and that exchange rates overshoot in Kenya. If exchange rates overshoot and this channel is effective in Kenya, then both would impact negatively on aggregate incomes. This paper therefore set out to establish how the effects of exchange rate overshooting are transmitted into the macroeconomic variables in Kenya. Empirical evidence to prove that exchange rates overshoot in Kenya was sort before its effects in the economy can be traced.

Two models were estimated in the paper. The first one aims at establishing for the evidence of exchange rate overshooting in Kenya under the floating exchange rate regime using quarterly data from 199:.:1 to 2001:4. The second model traces the transmission of exchange rate overshooting to the other macroeconomic variables in the economy using monthly data from January 1993 to December 2001. To establish for the evidence of exchange rate overshooting, due to the non-existence of co integration in the overshooting variables therefore making the estimation of an error correction model impractical, a short-run equation was estimated with the result that exchange rates overshoot in the short-run. The results of the short run overshooting equation show evidence for exchange rate overshooting in Kenya in the short run. The lags of money supply in the preferred model are positive up to the second quarter. This means that exchange rates overshoot on impact and reaches the overshooting peak at the end of the second quarter then starts to trace back its long ran path. The short run path and the long run path converge after eight months.

To trace the transmission of exchange rate overshooting in the economy, vector autoregression (VAR) analysis was used. A VAR (5) model was estimated and the results analyzed using impulse response analysis and variance decomposition analysis. The results from impulse response analysis show that exchange rate channel of monetary policy transmission mechanism is effective in Kenya and the tightening of monetary policy though this channel reduces aggregate output. It is found that prices are sticky in the short run and flexible in the long run while exchange rates and money supply adjustments from a monetary policy change are instantaneous. This leads to exchange rate overshooting its long run path in the short run. Therefore from the results of this study, it can be concluded that, sticky prices and money supply are the major causes of exchange rate overshooting in Kenya. From the impulse response analysis, a monetary policy change is neutralized after eight months. This gives evidence to the fact that exchange rates do not overshoot in the long run. Variance decomposition analysis further provides support for the effectiveness of the exchange rate channel of the monetary policy transmission mechanism