A cointegration between exchange rates, inflation and interest rates in Kenya

A move that Kenya made in 1993 concerning its trade policy allowed the Kenya Shilling to freely float. As a result Kenya's domestic prices became vulnerable to the effects of exchange rate fluctuations. One of the main determinants of inflation has been exchange rate movements and the Central Bank of Kenya has been working tirelessly to ensure that the country does not incur inflation by trying to maintain it at sustainable levels. As a result, the exchange rates movements have been closely monitored. For these reason this thesis examines the cointegrated relationship between exchange rates, inflation and interest rates in Kenya from the periods of January 1985: M1 to December 2010: M12. The data set consists of monthly observations of the inflation rates, interest rates and exchange rates (Kenya Shilling per US Dollar exchange rate). A unit root test is performed to test all the time series variables for stationarity. A cointegration test using Johansen (1991) and (1995) techniques is done on the variables, exchange rates, inflation and interest rates for Kenya. Similar tests will be carried out on data from Canada and Egypt to tell the story of the underlying differences between the countries and compared to Kenya's data.;This research concludes there is an existence of a long run relationship between the exchange rates and macroeconomic variables of interest rates and inflation. This relationship indicates the long run predictability of the exchange rate prices.