that ‘while exchange-rate risk does reduce the volume of trade among countries regardless of the nature of their exchange-rate regime, the greater risk faced by traders in floating exchange-rate countries is more than offset by the trade-reducing effects of restrictive commercial policies imposed by fixed exchange rate countries.’ This not only shows the direct economic impact an exchange rate regime can have on economic growth, but more specifically, the underlying problems associated with fixed exchange rate countries that also affect their trade, which is their strict policies outside of their currency regulations.
Increased exchange rate fluctuations would, for instance, increase the uncertainty of profits on contracts denominated in a foreign currency, and would therefore reduce economic growth to levels lower than would otherwise exist if uncertainty were removed (Cote, 1994).
Economic contraction occurs through the following channels. First, a nominal depreciation of the currency leads to a rise in general price level. This lowers aggregate demand, which, in turn, causes economic contraction. The second channel works through the income redistribution. It is argued that a real depreciation can help transfer income from individuals with a high marginal propensity to consume to those with a low marginal propensity. This lowers aggregate demand, which, in turn, causes output to fall. The aggregate supply channel, on the other hand, purports that the depreciation of the real exchange rate increases the cost of production and helps redistribute income in favor of the rich. It is contended that a real depreciation can reduce aggregate supply. This is so because a real depreciation causes the cost of imported raw materials to go up. This reduces the importation of raw materials and thereby lowering the level of aggregate supply (Papazoglou, 1999).
Eduardo and Berg (2000) show that the higher the level of dollarization or currency substitution in a country, the less effective will be the traditional set of monetary policies of the central bank. Actions on the part of the monetary authority relating to money market rates, reserve requirements, and refinancing may turn out to have insignificant effect on real GDP and inflation
Ndung’u (2001) suggest that there may not be one single solution applied to all situations and that the effect of exchange rate should be examined on a country to country basis. Balance how 22
large the impact is and when the impact occurs. The optional choice of exchange rate system is a long standing problem in open economic system.
Another analysis, done by Nabli and V”ganzon”s-Varoudakis (2002), looks at the Middle East and North African (MENA) countries that were characterized by having an overvaluation of their currencies throughout the 1970s and the 1980s. They were able to compute this overvaluation through the use of an ‘indicator of misalignment.’ A panel of 53 countries were used, and ten of these were MENA countries. Their research shows that manufactured exports were significantly affected by the overvaluation of their currencies. In the 1990s, when overvaluation was decreased within the MENA countries overall, there was also ‘a continuous rise in the diversification of their manufactured exports affecting the GDP of such countries. Through any 23
of these methods, the government may affect domestic relative prices and, therefore, the competitiveness of domestic industries.
In another study, Calvo and Mishkin (2003) take on a different view of exchange rate regimes. They argue that macroeconomic success in emerging market countries can be produced primarily through good fiscal, financial, and monetary institutions, and they believe that less emphasis should be placed on the flexibility of an exchange rate regime. They find that when choosing an exchange rate regime, not all countries are able to conform to one type. This is due to each countries particular needs and their economy, institutions, and political culture.
Fountas and Aristotelous (2003) on their paper the impacts of the different exchange rate regimes throughout the twentieth century on the bilateral exports between the United Kingdom and the United States. They concluded that fixed exchange rate regimes and managed float exchange rate regimes are equally favorable to trade, but, more importantly, freely floating exchange rate regimes produce more trade than fixed.
Fred Hu (2004) also finds a negative effect associated with using fixed exchange rate regimes on economic growth. His study focused on China in particular, and the need for this country to liberalize their currency and capital control. He concludes that China must go through a gradual process that will ultimately lead them to a more liberalized system overall. First, they must remove the currency peg causing them to have a free floating exchange rate. This would cause them to enter a more balanced trading field among their major trading partners. Second, they need to introduce a sound banking reform program, which would stabilize their domestic financial system. Lastly, China should relax their capital control policies. This would assist them in avoiding financial crisis while simultaneously allow them to gain more capital freedom. 24
Egert and Zumaquero (2005) analyzed the impact of exchange rate volatility and changes in the exchange rate regimes on export volume for ten Central and Eastern European transition economies. The first group of countries started their transition with pegged regimes and then moved towards flexibility. The second group of countries experienced no major changes in their exchange rate regimes in the past ten years. Their results indicate that an increase in the exchange rate volatility decreases exports, and this impact has a delay rather than being instantaneous.
There is, however, no available evidence that success has since been achieved in realizing the objective for which the foreign exchange market was liberalized. Large volatilities in nominal exchange rates have since characterized Kenya financial market (Kiptoo, 2007).
Modern analysts argued that flexible exchange rates are preferable to fixed exchange rates on the grounds that flexible exchange rates provide greater insulation from foreign shocks. By the end of 1998 many countries had allowed to float currencies against other. That is the currencies were not formally pegged to other currencies. However, exchange rate policy is still a source of exasperation, and appropriate choice is by no means clear (Frankel, 2007).
Kiptui and Kipyegon (2008) on their study on external shocks and real exchange movement in Kenya found that though external shocks have major effects on the real exchange rate, domestic shocks also play a role. The results show that the interest rate differential has significant negative (appreciating) effects in the short and long-run. On the other hand, government spending has significant positive (depreciating) effects on the real exchange rate in the short-run and long-run while real GDP growth has positive (depreciating) effects in the short-run but negative (appreciating) effects in the long-run. 25
Musyoki and Pundo (2012) study on the impact of real exchange rate volatility on economic growth: Kenyan evidence. Adduced evidence that the conditional volatility of the RER depended on both domestic and external shocks to RER fundamental and macroeconomic changes. Overall, however, Kenya’s RER generally exhibited an appreciating and volatility trend, implying that in general, the country’s international competitiveness deteriorated over the study period, hence, impacting negatively on the economic growth of Kenya.
Omondi (2012) study on the impact of exchange rate fluctuations on foreign direct investments in Kenya. From the collected data it was observed that while 1987 and 2002 recorded the lowest fluctuations in exchange rates and fairly low net foreign capital inflows into the country, conversely 1993 recorded the highest exchange rate fluctuations and the relatively high foreign direct inflows. This should point at a strong relationship between the two variables. However the inferential analyses found a weak relationship between exchange rate fluctuations and foreign direct investments. Hence the conclusions drawn from this study finding suggest that the impact of exchange rate fluctuations in attracting FDI is insignificant.
2.4.1 International Parity Relationships
Parity conditions are an explanation for the long-run value of exchange rates. They include: relative inflation rates (purchasing power parity), relative interest rates (Fisher effect), forward exchange rates, exchange rate regimes, and official monetary reserves. Interest rate parity connects the forward rate to the spot rate and interest rates in the domestic economy to those abroad (Sercu and Uppal, 1995).
An important major determinant of long-run behavior of real exchange rates is economic activity such as a rise in productivity or growth in manufacturing. These factors affect the overall quality and quantity of goods produced and consumed, the ‘national consumption basket. While there is agreement that growth in economic activity and differences in productivity influence the long-term real exchange rate, calculation of these effects are still debated (Solnik, 2000).
INDEPENDENT VARIABLES
INDEPENDENT VARIABLE
Intervening variables
study was stated as: Y=’+”_1 X_1+”_2 X_2+”_3 X_3+” ‘.” (3.2)
Chapter three
Research methodology
3.0 Introduction
This chapter presents the study design and methodology used in gathering information needed for the purpose of completing the study. This chapter involves a blueprint for the collection, measurement, and analysis of data. In this section the following subsections are included; research design, target population, samples, data collection, data validity and reliability and data analysis method as well as the instrument used in collecting data for the study and discuss how the data is collected, analyzed and interpreted.