The exchange rate and the interest rate differential in Kenya: a monetary and fiscal policy dilemma

The exchange rate and the interest rate differential in Kenya: a monetary and fiscal policy dilemma

Policy intervention could compound rather than solve Kenya's capital flow problems

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 parity are absorbed by the real interest rate differential in an error correction.

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.

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. The paper shows that closing the gap in the real interest rate differential (that is, lowering the domestic interest rate) will be consistent with a depreciation of the exchange rate. The optimal approach is not to sterilize these capital flows but to allow exchange rate movements to stabilize them in the medium to long term. Doing nothing in the presence of short-term capital flows is optimal. Effective policy intervention is likely to increase distortion and compound the problem.

[adapted from author]