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A Monetary Approach to Exchange Rate Dynamics in Low-Income Countries: Evidence from Kenya

By Boaz Nandwa and Ramesh Mohan

Abstract

The flexible price monetary model assumes that both the purchasing power parity (PPP) and uncovered interest parity (UIP) hold continuously. In addition, the model posits that money market equilibrium exists, which helps to determine the exchange rate. This paper explores exchange rate determination in low-income economies by applying a monetary model to Kenya to examine the exchange rate dynamics in a post-float exchange rate regime. We apply a multivariate cointegration and error correction model (ECM) to investigate whether the long-run exchange rate equilibrium and the rate of adjustment to the long-run equilibrium hold, respectively. Finally, we evaluate the relative performance of ECM versus a random walk framework in the out-of-sample forecasting. We find that the random walk performs better than the restricted model.

Topics: C32 - Time-Series Models; Dynamic Quantile Regressions; Dynamic Treatment Effect Models, F31 - Foreign Exchange, E58 - Central Banks and Their Policies, C53 - Forecasting and Prediction Methods; Simulation Methods
Year: 2007
OAI identifier: oai:mpra.ub.uni-muenchen.de:5581

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