Real exchange rate is an important indicator of competitiveness in the foreign trade of a country. Any changes in real exchange rates would therefore lead to fluctuations in capital flows. It is therefore important to align real exchange rates within the equilibrium levels to avoid negative consequences on the economy. This study sought to understand the determinants of real exchange rate alignment in Kenya using annual data from 1988 to 2019 using Autoregressive Distribution Lag (ARDL) model. The study estimated the long run and short run dynamics of real exchange rate alignment in Kenya. The ARDL bounds test confirmed that a long run relationship exists between real exchange rate and the explanatory variables. Real exchange rate was the dependent variable while the explanatory variables were external public debt, government expenditure, interest rate differentials and productivity differentials. The results revealed that external public debt, government expenditure and productivity differentials are significant determinants of real exchange rate alignment. Interest rate differential was found to be not significant. The Error Correction Model was found to be significant and having the right (negative) sign. This shows that Kenya’s real exchange rate adjusts to the long run equilibrium as a response short run shocks of previous periods. The speed of adjustment was found to be 86 percent per year. Both the long run and error correction models were found to be stable as per the CUSUM and CUSUMQ tests. The models also passed all the diagnostic tests including serial correlation, normality, heteroscedasticity, and multicollinearity.
Estimating long-run equilibrium real exchange rates: short-lived shocks with long-lived impacts on Pakistan