EFFECTIVENESS OF MONETARY POLICY INTERVENTION ON EXCHANGE RATE VOLATILITY IN KENYA

Abstract

Despite the monetary policy intervention in foreign exchange markets by Central bank of Kenya to stabilize the exchange rate and to reverse the growth in the country’s trade deficit through increased competition, Kenya has been facing wide fluctuations in US dollar to Kenya shilling exchange rates since the adoption of a floating exchange rate system in 1993 resulting to increased exchange rate risk. Other than the high volatility of exchange rate, there has been a continuous depreciation of Kenya shilling to US dollar. Depreciation of home currency decreases return on investment when investing internationally. This study aimed at evaluating the effectiveness of monetary policy on exchange rate volatility in Kenya using GARCH (1, 1) model. The specific objectives of the study were; to determine the effectiveness of net foreign exchange intervention, 91-day Treasury bill rate, Central bank rate and inflation on exchange rate volatility in Kenya. A descriptive longitudinal time series research design was used. Monetary policy intervention was found to be effective in reducing exchange rate volatility by use of foreign exchange intervention and Treasury bill rate. A unit decrease in 91-day Treasury bill rate decreases the exchange rate volatility by 2.5790 units while a unit increase in foreign exchange intervention decreases the volatility by 0.3042 units. Central bank rate has no effect on volatility. The finding of this study is of great significance to monetary policy makers and society at large. Since non-sterilized intervention was found to result into monetary policy dilemma, policy makers should strive for a policy mix that will ensure stable exchange rates by stemming out any excessive volatility in the exchange rate to avoid further depreciation and fluctuation on exchange rate. A combination of a stable exchange rate environment and a competitive currency will attract investment, increase aggregate output and expand country's economic prosperities.