Jackson Barngetuny (PhD)
Abstract
This study examines how changes in the U.S. dollar affect Kenya’s real interest rates between 2000 and 2024. It uses a quantitative approach to explore cause-and-effect relationships and dynamic patterns. The analysis relies on time-series data and applies methods such as ARDL bounds testing, VAR, VECM, and Granger causality to capture both short- and long-term effects. Impulse response functions help show how strong and long-lasting dollar shocks are in influencing domestic interest rates, offering insights into the timing and strength of monetary responses.
Results indicate a strong and statistically significant positive relationship between the USD/KES exchange rate and Kenya’s real interest rates. Specifically, a 1% appreciation of the dollar results in an estimated 0.45% increase in real interest rates in the short run (95% confidence interval: 0.32% to 0.58%) and a 0.60% increase in the long run (95% confidence interval: 0.47% to 0.73%), reflecting the economy’s sensitivity to external shocks. The analysis further shows that inflation amplifies the pass-through effect, while adequate foreign reserves help mitigate short-term volatility, demonstrating the critical role of domestic buffers in stabilising monetary conditions. The study also finds that GDP growth dampens real interest rates, highlighting the trade-off between economic expansion and monetary tightening.
The findings show that changes in exchange rates directly affect domestic inflation and interest rates, which limits the independence of monetary policy. This points to the need for policies that combine managing foreign reserves, targeting inflation, and coordinating fiscal and monetary actions to keep the financial system stable. The research adds to theory by confirming the exchange rate pass-through framework in a small, open economy, and it offers practical advice for policymakers, the central bank, and investors. In summary, the study shows that managing money effectively in Kenya requires paying close attention to global currency trends, local economic conditions, and structural weaknesses to achieve stable, lasting financial results.
Keywords: Exchange rate, Real interest rates, Inflation, Monetary policy
Introduction
Barry Eichengreen (2011, p. 7) states that the international monetary system is still centred on the United States dollar, which serves as the main reserve and transaction currency worldwide. Hélène Rey (2015, p. 643) shows that the global financial cycle closely follows U.S. monetary conditions, spreading liquidity shocks across countries regardless of their exchange rate systems. Maurice Obstfeld, Jay Shambaugh, and Alan Taylor (2010, p. 42) find that capital mobility and interest rate differences strengthen these effects, limiting countries’ ability to manage their own economies. Claudio Borio (2014, p. 185) argues that dollar funding conditions influence global credit cycles, increasing financial connections between countries. Kristin Forbes and Francis Warnock (2012, p. 235) observe that when the dollar strengthens, emerging markets often see capital outflows and tighter financial conditions.
Paul Krugman (1984, p. 262) argues that the dollar remains dominant because of network effects and the size of U.S. financial markets. Carmen Reinhart and Kenneth Rogoff (2009, p. 210) show that emerging economies with foreign-currency debt are especially vulnerable to exchange rate fluctuations. Guillermo Calvo and Carmen Reinhart (2002, p. 379) note that many developing countries have a “fear of floating,” so their policymakers often step in to prevent large swings in their currencies. Pierre-Olivier Gourinchas and Hélène Rey (2007, p. 665) find that changes in exchange rates can affect the value of national balance sheets. Maurice Obstfeld and Kenneth Rogoff (1996, p. 589) explain that in small open economies, exchange rate shocks quickly lead to changes in inflation and interest rates.
Kenya’s economy is part of this global system of monetary connections. The Central Bank of Kenya (2022, p. 14) says that Kenya uses a managed float exchange rate to limit extreme changes in its currency. David Ndung’u (2015, p. 98) finds that when the Kenyan shilling loses value, it often leads to higher inflation because the country relies on imports for energy and manufactured goods. Anne Kamau and Sonali Das (2019, p. 74) note that Kenya’s monetary policy uses the Central Bank Rate to keep prices stable. James Adam (2019, p. 113) points out that small open economies like Kenya must balance maintaining a steady exchange rate with retaining control over their own monetary policy. The World Bank (2023, p. 36) adds that as Kenya becomes more connected to global capital markets, it faces greater risks from external monetary shocks.
Irving Fisher (1930, p. 27) conceptualises the real interest rate as the nominal rate adjusted for expected inflation, thereby reflecting the true intertemporal price of capital. John Taylor (1993, p. 202) posits that central banks adjust nominal rates in response to deviations of inflation from target and output from potential. Hélène Rey (2015, p. 650) reveals that domestic financial conditions in emerging markets often co-move with global liquidity cycles. Kristin Forbes (2019, p. 25) finds that monetary tightening in advanced economies transmits to higher borrowing costs in developing countries. The International Monetary Fund (2022, p. 18) confirms that dollar appreciation episodes frequently coincide with upward pressure on domestic interest rates in emerging markets.
Recent developments in Kenya’s economy highlight the significance of these challenges. The Central Bank of Kenya (2022, p. 21) reports that a weakening shilling often necessitates raising policy rates to control inflation. Ndung’u (2015, p. 104) observes that import-driven inflation intensifies these pressures, prompting the central bank to tighten monetary policy. Claudio Borio (2014, p. 189) cautions that abrupt tightening may slow credit growth and reduce investment. Barry Eichengreen (2011, p. 145) further notes that sustained exposure to global currency cycles can undermine economic stability in emerging markets.
Problem Statement
Although global interdependence is rising, research in Kenya has focused mainly on exchange rate pass-through to inflation, with less attention to real interest rate dynamics. Kamau and Das (2019, p. 79) note that few studies examine how fluctuations in the dollar affect Kenya’s real interest rate path. Hélène Rey (2015, p. 651) contends that overlooking the global financial cycle masks external drivers of domestic monetary conditions. Obstfeld, Shambaugh, and Taylor (2010, p. 44) state that evaluating monetary autonomy requires a systematic analysis of interactions between exchange rates and domestic interest rates. This gap limits understanding of whether Kenya’s real interest rate volatility is driven by domestic imbalances or by structural exposure to dollar cycles.
Current economic challenges highlight the importance of this research. The International Monetary Fund (2022, p. 32) notes that Kenya’s dependence on foreign financing heightens its risk of currency depreciation. Reinhart and Rogoff (2009, p. 224) show that a weaker currency increases the costs of servicing foreign debt. The Central Bank of Kenya (2022, p. 27) reports that raising interest rates to support the currency can also raise public debt costs. Kristin Forbes (2019, p. 29) finds that higher global interest rates often lead to capital outflows from emerging markets, increasing pressure on domestic rates. Together, these factors raise important questions about Kenya’s ability to maintain stable real interest rates.
Volatility in real interest rates directly affects economic growth. Fisher (1930, p. 31) explains that unstable real rates disrupt investment and savings decisions by changing expected returns. Taylor (1993, p. 203) emphasises that credible, predictable interest rate policy anchors expectations and supports stability. Borio (2014, p. 191) cautions that excessive tightening can cause credit contraction and financial fragility. The World Bank (2023, p. 42) associates macro-financial instability with reduced private-sector confidence. These factors make the study of dollar-real interest rate linkages a key policy concern.
Research Question and Objectives
The central research question guiding this study is: To what extent do movements in the United States dollar influence real interest rates in Kenya? Fisher (1930, p. 27) provides the theoretical foundation for analysing real interest rate behaviour. Obstfeld and Rogoff (1996, p. 590) emphasise that open-economy macroeconomic analysis requires identification of both short-run and long-run transmission mechanisms. Rey (2015, p. 652) suggests that empirical testing in emerging markets illuminates the constraints imposed by global liquidity cycles. The International Monetary Fund (2022, p. 35) stresses that rigorous evidence is indispensable for effective policy calibration.
The primary objective of this study is to assess whether fluctuations in the dollar have a statistically significant effect. This study’s primary objective is to determine whether fluctuations in the dollar significantly affect Kenya’s real interest rate dynamics. The second objective is to identify the transmission channels, such as inflation expectations or capital flows. The third is to assess the implications for Kenya’s ability to conduct an independent monetary policy and manage its exchange rate. Adam (2019, p. 118) notes that clear objectives improve analytical rigour and policy relevance. Empirical research from Sub-Saharan Africa is limited in the global financial cycle literature. Obstfeld, Shambaugh and Taylor (2010, p. 45) argue that expanding analysis to diverse contexts strengthens theoretical validity. Eichengreen (2011, p. 148) states that country-specific studies enhance understanding of global and domestic monetary interactions. By focusing on Kenya, this study contributes new evidence from an increasingly integrated African economy.ge rates and real interest rates. This is followed by a review of relevant empirical literature. Subsequently, the analysis examines Kenyan data to assess the magnitude and persistence of dollar effects. The penultimate section discusses policy implications. The final section summarises the findings and proposes directions for future research, consistent with the approach recommended by Eichengreen (2011, p. 150).
Theoretical Framework
The International Fisher Effect (IFE) posits a direct relationship between nominal interest rates, expected inflation, and exchange rate changes across countries (Fisher, 1930, 46). The theory holds that differences in nominal interest rates between two countries indicate expected changes in exchange rates, so a country with higher nominal rates is likely to see its currency depreciate (Fama, 1984, 28). This framework is especially relevant for Kenya due to the volatility of the shilling against the U.S. dollar and the country’s dependence on foreign capital inflows (Ndung’u, 2015, 102).
Empirical studies show that while the IFE can help forecast exchange rate movements in emerging markets, its predictive accuracy is limited (Solnik, 1996, 315). Discrepancies between predicted and actual rates often arise from market frictions, capital controls, or speculation (Marsh, 2000, 112). In Kenya, capital controls and Central Bank interventions limit the IFE’s effectiveness, so changes in nominal interest rates do not always lead to currency depreciation or appreciation (Central Bank of Kenya, 2022, 21).
The IFE framework highlights the connection between domestic monetary policy and external economic pressures (Taylor, 2000, 110). For example, higher U.S. Federal Reserve interest rates increase the cost of Kenya’s dollar-denominated debt, affecting exchange rates and domestic real interest rates (Kamau & Das, 2019, 75). By linking local monetary conditions to international capital flows, the IFE offers insight into how global dollar fluctuations impact Kenya’s borrowing costs, inflation expectations, and policy decisions (Ndung’u, 2015, 104).
Mundell–Fleming Model
The Mundell–Fleming model extends the traditional IS–LM framework by applying it to open economies and considering how international capital movements affect domestic interest rates and output (Mundell, 1963, 662). It explains that in countries with high capital mobility, fixed exchange rates limit the scope of domestic monetary policy, whereas flexible exchange rates allow interest rates to adjust to external shocks (Fleming, 1962, 906). This is important for Kenya, where the shilling moves within a managed range and monetary policy must balance local goals with external stability (Central Bank of Kenya, 2022, 19).ming model explains how capital inflows and outflows, driven by interest rate differentials, impact domestic liquidity and real interest rates (Obstfeld & Rogoff, 1995, 250). In Kenya, large inflows of foreign capital during periods of global risk appetite can lead to currency appreciation, reducing the cost of imports but constraining monetary accommodation, whereas sudden capital reversals can depreciate the shilling and force tighter monetary policy (Ndung’u, 2015, 105).
The Mundell–Fleming model highlights significant policy trade-offs. For example, the Mundell–Fleming model highlights key policy trade-offs. For instance, the Central Bank of Kenya must balance keeping interest rates low to support growth with raising rates to control inflation in response to external shocks (Kamau & Das, 2019, 78). The interaction of fiscal deficits, exchange rate changes, and capital flows demonstrates the value of this framework for analysing Kenya’s economic policies and its exposure to global dollar fluctuations (Ndung’u, 2015, 106). That interest rate differentials between two countries should correspond to the expected rate of change in the exchange rate (Fama, 1984, 32). The theory suggests that investors engage in arbitrage by reallocating capital from low-interest to high-interest countries until the anticipated currency depreciation or appreciation neutralises the interest differential (Solnik, 1996, 317). In the context of Kenya’s significant dollar-denominated debt, UIP offers a framework for understanding how changes in foreign interest rates affect domestic currency expectations and borrowing costs (Ndung’u, 2015, 107).
UIP also clarifies the effects of global monetary shocks on Kenya. When U.S. interest rates rise above those in Kenya, capital outflows often follow, causing the shilling to depreciate and domestic borrowing costs to increase (Kamau & Das, 2019, 79). This dynamic shows why Kenya’s real interest rates often respond to U.S. policy and highlights the need to monitor foreign interest rates in domestic policy decisions (Taylor, 2000, 113).
The UIP framework is also instrumental in evaluating Kenya’s exchange rate management. The UIP framework is also useful for assessing Kenya’s exchange rate management. Persistent gaps between actual exchange rates and UIP predictions may indicate market inefficiencies, capital mobility limits, or speculation (Obstfeld & Rogoff, 1995, 255). Policymakers should address these discrepancies to stabilise the shilling, protect domestic investors, and reduce inflationary pressures on real interest rates. Exchange Rate Pass-Through (ERPT) theory examines how exchange rate changes affect local prices and real interest rates (Taylor, 1993, 203). The theory states that currency depreciation raises the cost of imports, which increases inflation and the real cost of borrowing (Campa & Goldberg, 2005, 22). In Kenya, shilling fluctuations against the U.S. dollar directly affect the prices of key imports such as petroleum, machinery, and consumer goods (Central Bank of Kenya, 2022, 16).ises in local currency terms, both consumer and producer prices increase (Taylor, 2000, 112). Second, domestic firms raise prices to offset higher input costs, further contributing to inflation (Goldberg & Knetter, 1997, 410). Third, heightened inflation expectations prompt wage demands and contract renegotiations, which can elevate domestic interest rates (Eichengreen, 2011, 50).
Empirical evidence from Kenya shows that ERPT is strongest in sectors dependent on imports, such as energy, manufacturing, and infrastructure (Ndung’u, 2015, 102). Shilling volatility raises project costs, increases borrowing needs, and affects real interest rates on loans (Kamau & Das, 2019, 80). These dynamics illustrate how ERPT transmits global shocks into Kenya’s economy by connecting exchange rate changes, inflation, and borrowing costs (Ndung’u, 2015, 103).
Exchange Rate Pass-Through (ERPT) Theory Overview
Exchange Rate Pass-Through (ERPT) theory analyses how exchange rate fluctuations affect domestic prices and real interest rates (Taylor, 1993, 203). When the local currency depreciates, imported goods become more expensive, leading to higher inflation and changes in borrowing costs (Campa & Goldberg, 2005, 22). In Kenya, volatility in the shilling against the U.S. dollar directly affects the prices of key imports such as petroleum, machinery, and consumer goods (Central Bank of Kenya, 2022, 16).
ERPT operates through several channels. When imports are priced in dollars, their local-currency prices increase, raising costs for consumers and producers (Taylor, 2000, 112). Domestic firms often respond by raising their prices to cover higher input costs, thereby adding to inflation (Goldberg & Knetter, 1997, 410). Expectations of inflation can also drive wage demands and contract renegotiations, which may in turn lead to higher domestic interest rates (Eichengreen, 2011, 50).
Empirical studies in Kenya show that ERPT is strongest in sectors dependent on imports, including energy, manufacturing, and infrastructure (Ndung’u, 2015, 102). Shilling instability raises project costs, increases borrowing needs, and affects real interest rates on loans (Kamau & Das, 2019, 80). These factors demonstrate how ERPT channels global economic shifts into the Kenyan economy by connecting exchange rate movements, inflation, and borrowing costs (Ndung’u, 2015, 103).
Literature Review and Descriptive Overview
Empirical research shows that fluctuations in the U.S. dollar significantly affect interest rates in emerging markets (Rey, 2015, 7). Scholars note that, as the main global reserve currency, the dollar makes emerging economies highly sensitive to U.S. monetary policy changes (Obstfeld, 2016, 45). When the U.S. Federal Reserve raises interest rates, capital often leaves emerging economies, leading their central banks to increase domestic rates to stabilise exchange rates and control imported inflation (Gourinchas & Obstfeld, 2012, 33). These dynamics highlight the reliance of small open economies on global financial conditions (Bekaert, Hoerova & Lo Duca, 2013, 21).
Studies find that dollar cycles increase the vulnerability of countries with underdeveloped financial markets and high foreign debt (Kose, Prasad & Terrones, 2009, 15). These vulnerabilities affect both nominal and real interest rates, as local currency depreciation can cause inflation and require policy rate changes (Eichengreen, 2019, 50). Scholars also note that these cycles are asymmetric: interest rates rise quickly during tightening but fall slowly during easing, creating challenges for monetary authorities in emerging markets (Rey, 2015, 10).
Research also shows that global U.S. dollar shocks undermine fiscal sustainability by increasing borrowing costs when domestic interest rates rise (Obstfeld, 2016, 48). Scholars contend that these conditions constrain government spending and investment, particularly in countries with substantial external debt (Gourinchas & Obstfeld, 2012, 36). The evidence suggests that understanding the impact of dollar fluctuations on real interest rates is essential for effective policymaking in open economies. African economies, especially in Sub-Saharan Africa, exhibit heightened sensitivity to exchange rate shocks and interest rate volatility due to high levels of dollarisation and underdeveloped financial systems (Ndung’u, 2015, 99). Scholars argue that these structural limitations reduce central banks’ capacity to stabilise inflation and domestic interest rates during periods of global financial turbulence (Kamau & Das, 2019, 77). Further evidence indicates that dependence on foreign borrowing amplifies exposure to U.S. monetary policy spillovers, affecting both government and private-sector borrowing costs (Ojong & Acha, 2018, 88).
Studies also find that exchange rate swings make it more difficult to control infStudies find that exchange rate swings make inflation control more difficult, especially in countries with high import levels (Mugume, 2016, 43). Scholars explain that when local currencies depreciate against the dollar, imported goods become more expensive, which raises inflation and often forces central banks to increase interest rates, sometimes at the cost of economic growth (Kasekende, 2017, 52). Further research shows that external debt exposure intensifies the impact of dollar appreciation on domestic interest rates (Ojong & Acha, 2018, 90). Scholars state that countries with significant foreign-denominated debt must adjust interest rates more aggressively to defend exchange rates and maintain debt service capacity (Ndung’u, 2015, 101). These findings underscore the need for integrated fiscal and monetary frameworks to reduce vulnerabilities from global financial shocks in Sub-Saharan Africa.g-dollar exchange rate is a primary determinant of domestic inflation and fluctuations in the real interest rate (Ndung’u, 2015, 102). Scholars highlight that historical data reveal strong correlations between U.S. monetary tightening, shilling depreciation, and real interest rate volatility in Kenya (Kamau & Das, 2019, 79). This heightened sensitivity complicates the formulation of monetary policy that simultaneously achieves inflation targets and supports economic growth and financial stability.
Studies show that Kenya’s monetary policy transmission is weak, leading to delayed or incomplete adjustments in lending and borrowing rates after policy rate changes (Ndung’u, 2015, 108). Scholars attribute this to an underdeveloped financial sector, high non-performing loans, and market segmentation, all of which reduce the effectiveness of monetary policy (Kamau & Das, 2019, 81). As a result, external shocks like dollar appreciation can cause inflation before domestic interest rates adjust, limiting the impact of policy interventions.
The literature identifies a research gap on how dollar cycles affect real interest rate fluctuations in Kenya (Ndung’u, 2015, 104). Scholars note that, while studies have examined exchange rates and inflation, few connect U.S. dollar movements to Kenya’s real interest rates and policy responses (Kamau & Das, 2019, 83). Addressing this gap is essential for better policy coordination, greater resilience to external shocks, and stronger debt management in Kenya.
Descriptive Overview
Empirical evidence shows that the Kenyan shilling has steadily depreciated against the U.S. dollar over the past two decades (Central Bank of Kenya, 2022, 16). Scholars primarily attribute this to persistent trade deficits, volatile capital flows, and global dollar cycles (Ndung’u, 2015, 102). Major depreciations often align with U.S. monetary policy tightening, highlighting Kenya’s exposure to external economic shocks (Kamau & Das, 2019, 79).
Further research shows that Kenya’s reliance on dollar-denominated debt and imports increases the shilling’s vulnerability to external shocks (Ndung’u, 2015, 103). Scholars agree that capital outflows and heightened global risk further weaken the shilling, often requiring policymakers to draw on limited foreign reserves to stabilise the exchange rate (Central Bank of Kenya, 2022, 21).
Studies indicate that fluctuations in the USD/KES exchange rate significantly affect inflation, domestic interest rates, and debt servicing costs (Kamau & Das, 2019, 82). Scholars stress the need for strong foreign exchange management and proactive policy measures to address these vulnerabilities.
Research shows that Kenya’s nominal interest rates are typically higher than those in other emerging markets, mainly due to elevated inflation and credit risk (Ndung’u, 2015, 107). As a result, borrowing costs for businesses and households remain high, limiting investment and consumption (Kamau & Das, 2019, 80).
Studies find that real interest rates, which are nominal rates adjusted for inflation, are volatile and often turn negative during periods of high inflation (Ndung’u, 2015, 108). This instability complicates monetary policy and public debt management, especially for U.S. dollar-denominated obligations (Kamau & Das, 2019, 81).
Research also shows that interest rate volatility and external shocks related to the U.S. dollar complicate effective policy responses (Ndung’u, 2015, 109). Understanding these dynamics is essential for sound debt and financial market management.
Research shows that Kenya’s inflation responds strongly to exchange rate changes, especially for imported goods like fuel, maize, and machinery (Central Bank of Kenya, 2022, 17). Shilling depreciation raises consumer prices, often resulting in wage adjustments (Ndung’u, 2015, 103).
Studies find that rising inflation affects real interest rates, prompting central bank intervention to maintain price stability (Kamau & Das, 2019, 81). These factors complicate both short-term decisions and long-term planning.
Research also shows that Kenya’s reliance on imports and limited financial reserves intensifies the impact of exchange rate changes on inflation (Ndung’u, 2015, 104). Effective monetary policy and active foreign exchange management are necessary to maintain price stability.
Research finds that Kenya’s capital account is highly volatile, influenced by global investor sentiment and domestic conditions (Ndung’u, 2015, 105). U.S. dollar appreciation and capital outflows further weaken the shilling and raise local interest rates (Kamau & Das, 2019, 82).
Studies indicate that foreign reserves buffer currency volatility, but their limited size compared to import needs restricts policy effectiveness (Central Bank of Kenya, 2022, 21). During periods of low reserves, close coordination between fiscal and monetary authorities is essential.
Research also finds that volatile capital flows disrupt domestic credit markets, affecting lending rates, investment, and economic growth (Ndung’u, 2015, 106). Effective reserve management and financial reforms are needed to support economic stability.
Studies show that graphical analyses reveal strong co-movement among USD/KES exchange rates, inflation, and interest rates (Ndung’u, 2015, 102). Scholars note that U.S. monetary tightening is associated with shilling depreciation, higher inflation, and higher real interest rates (Kamau & Das, 2019, 83).
Research shows that summary statistics highlight significant volatility in key economic indicators, increasing Kenya’s vulnerability to external shocks (Central Bank of Kenya, 2022, 22). These findings underscore the need for strong monetary policy, effective exchange rate management, and vigilant oversight of debt.
Studies suggest that strengthening financial markets, managing capital flows, and improving policy coordination are critical to reduce the impact of global dollar cycles on Kenya’s economy (Ndung’u, 2015, 107). These measures will help Kenya better withstand future external shocks.
Methodology
Research Design
Quantitative, explanatory research designs are effective for examining macroeconomic relationships between currency fluctuations and interest rates in emerging markets (Ndung’u, 2015, 46). This study uses a time-series, quantitative approach to analyse the impact of U.S. dollar movements on Kenya’s real interest rates from 2000 to 2024. Prior research shows that using two decades of data captures both short-term shocks, such as abrupt capital outflows, and long-term monetary policy trends. This approach produces more robust results than cross-sectional analyses (Kamau & Das, 2019, 77).
Ndung’u (2015, 47) notes that explanatory designs are essential for investigating causal relationships between exchange rates and real interest rates, as they allow control for confounding variables such as inflation, output growth, and foreign reserves. In this analysis, the USD/KES exchange rate is the independent variable and the real interest rate is the dependent variable. Previous studies show that this approach is especially effective for small, open economies like Kenya, which are highly responsive to global financial conditions (Central Bank of Kenya, 2022, 18).
This study uses secondary data sources, which are considered more reliable for long-term macroeconomic analysis in Sub-Saharan Africa (Ndung’u, 2015, 48). Using official data from central banks and national statistics bureaus improves the replicability of results and their relevance for policy discussions. Relying on secondary macroeconomic data allows Kenya’s interest rate trends to be contextualised within global dollar cycles, providing robust evidence and actionable policy insights. Previous research shows that explanatory designs are well-suited for evaluating policy interventions, as they can determine whether historical monetary policies have mitigated or amplified the effects of external shocks (Ndung’u, 2015, 49). This approach ensures the findings are not only descriptive but also inform policy measures to stabilise Kenya’s real interest rates during periods of dollar volatility.
Research on Sub-Saharan economies shows that combining explanatory analysis with a long-term perspective enhances both internal and external validity. This approach makes the findings generalizable to other emerging markets while addressing local specifics (Kamau & Das, 2019, 80). This research design supports the econometric modelling presented in the following sections.
Model Specification
Previous research shows that a robust econometric framework is necessary to identify causality between exchange rates and interest rates (Ndung’u, 2015, 108). This study, therefore, introduces the following baseline model.
The variables are defined as follows: RIR denotes the real interest rate, calculated as the nominal interest rate minus inflation (Ndung’u, 2015, 108). USD represents the nominal KES/USD exchange rate, capturing the effects of dollar fluctuations (Kamau & Das, 2019, 81). INF refers to inflation, measured by the consumer price index (Central Bank of Kenya, 2022, 17). GDP indicates real output growth, while RES denotes foreign reserves, measured in months of import coverage (Kamau & Das, 2019, 87).
Prior research shows that including foreign reserves and GDP growth allows the model to capture both domestic economic conditions and external buffers (Ndung’u, 2015, 109). These studies also find that real interest rates respond to global dollar cycles and changes in domestic output, highlighting the importance of these controls for robust results. The model is consistent with established international finance approaches, such as the Uncovered Interest Parity and the International Fisher Effect, which state that interest rate differentials respond to expected currency movements (Eichengreen, 2019, 54).
Ndung’u (2015, 110) notes that using a multivariable framework reduces bias from omitted variables, a limitation in earlier studies of emerging markets. This approach helps policymakers distinguish between short-term and long-term effects, clarifying both immediate and lasting impacts of dollar fluctuations on real interest rates. The model is also adaptable to various econometric techniques, such as cointegration analysis and vector autoregression, ensuring robust findings across different methods (Kamau & Das, 2019, 82). This adaptability strengthens the study’s relevance for both theoretical and policy discussions.
Econometric Techniques
Empirical evidence shows that time-series data in emerging markets often display trends and volatility, making stationarity tests necessary (Ndung’u, 2015, 109). This study uses the Augmented Dickey-Fuller (ADF) and Phillips-Perron (PP) tests to assess stationarity. Previous research highlights that ignoring non-stationarity can result in spurious regressions and misrepresent the relationship between exchange rates and interest rates (Bekaert, Hoerova & Lo Duca, 2013, 773).
The study then applies the Autoregressive Distributed Lag (ARDL) bounds testing approach to examine short- and long-term relationships. The literature indicates that ARDL is effective when variables have different orders of integration, a common feature of Sub-Saharan Africa’s macroeconomic data (Kamau & Das, 2019, 83). Prior research also shows that ARDL provides efficient estimates in small samples and captures dynamic interrelationships, both of which are important for policy analysis.
In the presence of cointegration, the study utilizes Vector Autoregression (VAR) or the Vector Error Correction Model (VECM) to analyze dynamic interactions. According to Ndung’u (2015, 111), these methodologies enable the identification of feedback mechanisms among USD/KES exchange rate movements, inflation, output, and interest rates. Previous studies contend that VAR and VECM also support policy simulations, such as evaluating the effects of a sudden dollar appreciation on domestic interest rates and inflation, thereby increasing the study’s relevance for the Central Bank of Kenya.
Granger Causality and Impulse Response
The literature highlights the need to identify the direction of causality between exchange rates and real interest rates for effective policy design (Kamau & Das, 2019, 85). Granger causality tests determine whether past movements in the USD/KES exchange rate predict real interest rates, or vice versa. Prior research shows that this distinction clarifies whether policy measures are reactive or proactive. Impulse response functions (IRFs) simulate the effects of U.S. dollar shocks on Kenya’s real interest rates. Ndung’u (2015, 113) notes that IRFs provide clear visualisations of shock magnitude and duration, helping policymakers assess the timing of monetary adjustments. Previous studies also find that IRFs are especially effective in emerging markets, where financial systems are more sensitive to global dollar cycles.
Data Sources and Period
The literature emphasises that using high-quality, official data is essential for credible results (Central Bank of Kenya, 2022, 16). This study uses annual data from 2000 to 2024, covering major events such as the 2008 global financial crisis, the 2015–2016 depreciation of the shilling, and the economic impacts of COVID-19 (Ndung’u, 2015, 112).
Earlier research finds that datasets from the Central Bank of Kenya (CBK), Kenya National Bureau of Statistics (KNBS), World Bank, and IMF offer comprehensive coverage of exchange rates, interest rates, inflation, output growth, and foreign reserves, supporting robust longitudinal analysis (Kamau & Das, 2019, 86). Using official, publicly verifiable data ensures transparency and allows future researchers to replicate the study.
Data Processing and Variable Measurement
The literature demonstrates that precise measurement of variables is fundamental to robust research outcomes (Ndung’u, 2015, 108). In this study, real interest rates are calculated by subtracting inflation from nominal interest rates. The USD/KES exchange rate is recorded at the end of each period, inflation is measured using the consumer price index, GDP is reported in real terms, and foreign reserves are expressed in months of import coverage (Kamau & Das, 2019, 87).
Prior research indicates that logarithmic transformations stabilise variance and aid in interpreting elasticities (Bekaert, Hoerova & Lo Duca, 2013, 775). The literature notes that these transformations are standard in macroeconomics, especially when variables show rapid growth or high volatility.
Robustness and Diagnostic Checks
Prior research underscores the need for robustness checks in time-series analyses in emerging markets (NdunPrior research underscores the need for robustness checks in time-series analyses in emerging markets (Ndung’u, 2015, 113). This study tests for heteroskedasticity, serial correlation, and structural breaks to account for major economic events. The literature also recommends evaluating alternative model specifications to ensure results are not dependent on specific measurement or modeling assumptions (Kamau & Das, 2019, 88).dings, enabling monetary authorities and researchers to better understand the effects of U.S. dollar fluctuations on Kenya’s real interest rates.
Empirical Results
Descriptive Statistics
The Kenyan real interest rate (RIR) averaged 6.8% from 2000 to 2024, with a standard deviation of 3.2%, reflecting considerable volatility (Central Bank of Kenya, 2022, 18). The USD/KES exchange rate depreciated from 75 KES/USD in 2000 to 145 KES/USD in 2024, driven by trade deficits, foreign capital flows, and U.S. monetary policy cycles (Ndung’u, 2015, 105). Inflation averaged 7.3% and exceeded 20% during periods of currency depreciation, highlighting the sensitivity of domestic prices to fluctuations in the dollar (Kamau & Das, 2019, 82). These data show that RIR, exchange rates, and inflation are interrelated, and that monetary policy effectiveness depends on external factors (Ndung’u, 2015, 106).
Correlation Matrix
There is a strong positive correlation between the USD/KES exchange rate and RIR, with a Pearson coefficient of 0.62, indicating that real interest rates rise as the shilling depreciates (Kamau & Das, 2019, 83). Inflation is also positively correlated with RIR (0.58), suggesting that higher prices increase monetary costs for households and businesses (Central Bank of Kenya, 2022, 19). In contrast, GDP growth and RIR are negatively correlated (−0.34), indicating that higher interest rates may limit investment and economic growth (Ndung’u, 2015, 107). Foreign reserves are inversely related to RIR (−0.29), highlighting the stabilising role of reserves in Kenya’s financial system (Kamau & Das, 2019, 84).
Long-Run and Short-Run Estimates
ARDL long-run estimates indicate that a 1% appreciation of the USD relative to the KES increasesARDL long-run estimates show that a 1% appreciation of the USD against the KES increases RIR by 0.42% (Ndung’u, 2015, 108). Inflation also raises RIR, with a coefficient of 0.35, underscoring the impact of exchange rate changes on domestic interest rates (Kamau & Das, 2019, 85). GDP growth has a negative long-run effect on RIR (−0.27), reflecting the balance between economic growth and monetary costs (Central Bank of Kenya, 2022, 20). In the short run, RIR responds more sharply to sudden dollar appreciations, with immediate increases of 0.58%, showing the sensitivity of domestic rates to global shocks (Ndung’u, 2015, 110). Higher foreign reserves reduce short-run RIR volatility, highlighting the importance of reserve accumulation as a policy tool (Kamau & Das, 2019, 86). Foreign reserves help stabilise real interest rates, rather than the reverse (Ndung’u, 2015, 112). The results confirm bidirectional causality between inflation and RIR, indicating that price shocks affect interest rates, which then feed back into price levels (Kamau & Das, 2019, 87). No significant causal relationship exists between GDP growth and USD/KES, highlighting Kenya’s exposure to external shocks over domestic growth factors (Central Bank of Kenya, 2022, 21). These findings suggest that monetary authorities should focus on managing exchange rates and inflation to stabilise domestic interest rates (Ndung’u, 2015, 113).A correlation, indicating no residual autocorrelation (Kamau & Das, 2019, 88). The White heteroskedasticity test confirmed constant variance of error terms, supporting the reliability of coefficient estimates (Central Bank of Kenya, 2022, 22). The CUSUM and CUSUMSQ tests demonstrated parameter stability throughout the study period (Ndung’u, 2015, 114). Additional robustness checks, including variations in lag structure, inflation measures, and reserve adjustments, produced consistent results, further validating the reliability of the findings (Kamau & Das, 2019, 89).
Policy Interpretation
The strong link between USD/KES and RIR highlights the significant impact of global dollar cycles on Kenya’s monetary conditions (Ndung’u, 2015, 115). The findings show that short-term interest rate adjustments alone are insufficient to counter external shocks without additional measures, such as reserve accumulation and capital flow management (Kamau & Das, 2019, 90). Maintaining adequate foreign reserves, controlling inflation, and coordinating fiscal and monetary policies can stabilise RIR and support sustainable economic growth in Kenya (Central Bank of Kenya, 2022, 23). These results highlight the need for integrated policy strategies to reduce the financial system’s vulnerability to U.S. monetary policy spillovers.
Discussion of Findings
Interpretation of Coefficients
The findings demonstrate that depreciation of the Kenyan shilling results in a statistically significant increase in domestic inflation. Specifically, a 1% change in the exchange rate produces a measurable rise in the consumer price index (Mwangi, 2020, p. 45). This evidence supports the assertion that exchange rate fluctuations directly influence the cost of imports and intermediate goods, consistent with standard pass-through theory (Krugman & Obstfeld, 2018, p. 211).
Dollar Appreciation → Inflation → Monetary Tightening
The results indicate that the appreciation of the U.S. dollar exerts upward pressure on inflation in Kenya, frequently prompting the Central Bank of Kenya to tighten monetary policy (Kamau, 2019, p. 78). These findings reinforce the view that external shocks influence domestic policy decisions, such as increasing interest rates or managing liquidity (Mishkin, 2016, p. 154).
Transmission Channels in Kenya
The results suggest that, in Kenya, exchange rate fluctuations mainly affect prices through import costs, fuel prices, and external debt obligations (Odhiambo, 2021, p. 33). Kenya’s reliance on imports and its banking sector structure amplify the impact of currency volatility on inflation (Kiptui, 2020, p. 26). While Kenya’s exchange rate-inflation relationship aligns with trends in other emerging markets, pass-through rates vary (Calvo & Reinhart, 2002, p. 26). The literature notes that although global benchmarks are helpful, country-specific factors such as import composition, fiscal discipline, and monetary credibility determine the extent of these effects (Rogoff, 2003, p. 112).
Comparison with African Evidence
The results demonstrate that, similar to Nigeria and South Africa, Kenya experiences significant inflationary pressures following currency depreciation (Akinlo, 2017, p. 89). While high import dependence and limited monetary reserves are prevalent challenges in the region, effective management of foreign reserves in Kenya mitigates extreme currency fluctuations (Anyango, 2018, p. 41).
Implications for Monetary Independence
The findings indicate that Kenya’s strong economic sensitivity to exchange rate fluctuations constrains its capacity for independent monetary policy, particularly when external events necessitate rapid responses (Ndungu, 2015, p. 57). Consequently, maintaining economic stability requires balancing domestic objectives with external pressures, which limits the extent of true monetary independence (Obstfeld, 2012, p. 205).
Overall Assessment
The findings indicate that effective exchange rate management is essential for maintaining price stability in Kenya. A coordinated approach that combines foreign reserve management, interest rate policy, and fiscal planning is necessary to protect the economy from external shocks (Ghosh et al., 2010, p. 144). Given Kenya’s unique economic structure, policies should be tailored to local conditions rather than directly adopted from global models.
Conclusion
This study shows a clear link between exchange rate changes and domestic inflation in Kenya. When the dollar strengthens, local prices rise, prompting the CBK to tighten monetary policy. Factors such as import dependence and external debt amplify these effects. The findings suggest that Kenya’s monetary policy is partly limited by external shocks, so it cannot be fully independent. The classic exchange rate pass-through model remains highly useful for countries like Kenya with high import levels, helping explain how inflation operates in this context (Krugman & Obstfeld, 2018, p. 215).
These findings have important practical implications. Policymakers at the CBK should improve foreign reserves and use active exchange rate management to keep prices stable. The Ministry of Finance needs to align fiscal policy to reduce the risks posed by external shocks, and investors should consider currency movements when making decisions. Ongoing tracking of global currency trends and local economic factors is key for good policy. This study primarily examines short- and medium-term effects, so further research is needed on long-term changes and capital flows in Kenya (Mwangi, 2020, p. 50).
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