Foreign Exchange Rate Volatility and Its Effect on International Trade in Kenya

Abstract

Exchange rate volatility has received much attention in economic research especially with the advent of floating exchange regimes. The volatile nature of exchange rate is generally perceived as having negative affect on international trade. However, the theoretical and empirical perspective are mixed on the nature of the relationship. This study aimed at examining analyzing the moderating effect of foreign exchange reserves on the relationship between foreign exchange rate volatility and international trade in Kenya. The study used error correction model in the analysis of the time series data for the study period which spanned between 1966-2018. Results show that controlling for inflation rate, interest rate and gross domestic product, foreign exchange reserves had a positive and statistically significant moderating effect at 5% significant level on the relationship between foreign exchange rate volatility and international trade with R2 of 0.9557. The study recommends maintaining enough stock of foreign exchange reserves to cushion the economy from adverse effects of exchange rate volatility. The findings of the study will provide relevant information in the formulation of and implementation of an effective monetary policy that will promote exchange rate stability and improve the country’s performance in international trade.