Is There a Relationship Between Inflation Volatility and Exchange Rate Fluctuation? The Extent to Which the Purchasing Power Parity Theory Holds in the Kenya Context

Abstract

Foreign exchange rate is one of the main macroeconomic variables that affect the economy of a country. Exchange rate affects the level of investment in a country, price stability and the balance of trade. Various macroeconomic factors have been identified by various authors as contributing to fluctuation in exchange rate. This includes among others relative inflation, interest rates, income levels, government interventions and market expectations. The aim of this study was to investigate the relationship between inflation volatility and exchange rate fluctuation in Kenya. The study relied on the hypothesis of purchasing power parity theory of existence of a negative relationship between inflation and exchange rate movement. The research aimed at establishing the extent to which the Purchasing Power Parity (PPP) theory holds in Kenya. The research
was for a period of nine years from January 2005 up to December 2013.Secondary data for exchange rate movement were obtained from the Central Bank of Kenya while data for inflation was obtained from the Kenya National Bureau of Statistics. This two are government institutions and therefore the credibility of data was assured. Regression analysis was applied to analyze the data in order to establish the relationship that exists between the two variables. The result from data analysis indicates the existence of a moderate negative relationship between movement in inflation and exchange rate volatility. This finding therefore supports the existence of PPP concept in Kenya during the period of study. The finding also indicates other factors also greatly influence movement in exchange rate and therefore inflation cannot be relied up on as the sole factor determining exchange rate.