CHAPTER 2

2.1. LITERATURE REVIEW

A review of the literature, as offered by different writers and experts, is included in this
chapter according to the study's aims. The literature review explains the theoretical
foundation for the issue under investigation, as well as what previous research has been done
and how it relates to the current issue. It also provides a critical overview of the topics
covered, both theoretically and empirically, in the body of research on the impact of
government policy on the exchange rate. The following aspects have been taken into
consideration for this topic's evaluation.
2.2 THEORETICAL LITERATURE REVIEW
PURCHASING POWER PARITY
According to the purchasing power parity theory of exchange rates, when two countries'
currencies have the same purchasing power, their exchange rates are in an equilibrium state.
This suggests that the ratios of the prices of a specified basket of goods and services in the
two countries should match the exchange rate between them. For instance, a nation's
exchange rate needs to decline in order to restore purchasing power parity when that nation's
domestic price level rises. By codifying the pricing of two distinct types of goods and
computing their corresponding exchange rates using the geometric mean, the purchasing
power parity theory establishes the behavior of exchange rates between states.
There exist two varieties of purchasing power parity: the relative and absolute ppp.
According to the Absolute PPP, two countries' national basket prices for goods and services
should be equalized through exchange rate adjustments. According to the theory of relative
purchasing power parity, a good should have the same value in two separate countries.
According to the RPPP, there is a connection between price inflation and exchange rates, and
inflation lowers the real purchasing power of a currency. Therefore, inflation needs to be
considered in order to appropriately adjust purchasing power parity.

The following formula can be used to get the purchasing power parity:

The spot exchange rate is calculated as follows: Cost of good W (in currency x) / Cost of
good W (in currency Y)

THE LAW OF ONE PRICE

The law of one price provides understanding the effect of government policy on the exchange
rates in various ways:
A. If the government implements zero rates on all exports, this may in turn lower the cost of
the same commodities locally and hence increasing their demand in the foreign markets. This
leads to increase in exports hence increasing foreign currency reserve locally eventually
causing a depreciation of the local currency.
B. Suppose the government were to increase import duty, this increases the cost of imported
goods locally. This will exert pressure on the exchange rate as domestic consumption of
foreign commodity increases due to increase demand of foreign commodities.
Contractual monetary policies such as increased interest rates discourage investment and
borrowing hence leading to depreciation of local currency and vice versa.
Contractual fiscal policies such as increased taxation reduces activities economically hence
reducing demand for foreign commodities hence appreciation of the shilling and vice versa.

2.3 Conceptual Framework

Fiscal policy

Monetary policy

Exchange rate

Trade policy
2.4 Empirical literature
There have been many studies carried out to link the relationship between changes in
government policies and the country’s exchange rate. Anne & Rose (n.d.) set out to
investigate how the exchange rate in Kenya responds to central bank interventions and
announcements related to monetary policy. The event study method was used & the
movements analyzed were those of the Kenyan exchange rate vs the US dollar, Sterling
pound and the Euro around the time of the events and announcements for the period 2000-
2012. Among other findings, the study found out during periods of loose monetary policy
accompanied with central bank purchases of securities, the exchange rates tend to depreciate.
Inversely, when monetary policy was tight and the central bank was actively shrinking their
holdings, exchange rates tend to appreciate. The study concluded that central bank
intervention in the forex market and announcements of policy change have a significant
impact on exchange rates which varies depending on the nature of the intervention and
prevailing policy regime.
Cavallo et al. (2005) tried to establish why a currency crisis in a country with high foreign
debt levels tend to experience major exchange rate fluctuations where the currency is mostly
depreciating and a significant output contraction. To empirically explain this, a small open
economy model was developed to show relationship between the Debt levels and the
exchange rate fluctuations and the contraction in output. It was proven that countries with
high foreign debt during and after a currency crisis experience significant exchange rate
fluctuations.
Kandil (2007) studied the effect of exchange rate fluctuations on real output, balance of
payment, real value of components of aggregate demand and the price level in Turkey. The
model divided movements in the exchange rate into two categories, expected and unexpected
components. The study investigates data from the period 1980-2004. Unexpected currency
fluctuations assisted in determining aggregate demand via exports, imports and demand for
domestic currency, aggregate supply was determined through cost of intermediate imported
goods and producers’ prediction of relative competitiveness. Unexpected exchange rate
fluctuations, whether appreciation or depreciation, have significant effects. Currency
depreciation makes exports more attractive while increasing cost of production. Inversely,
currency appreciation makes exports less attractive and cheaper to produce. It is shown that
expected appreciation of the exchange rate has a positive effect on Inflation and negative
effect on investor sentiment. This study however did not manage to include changes in
monetary policies on the exchange rate.
In their analysis, Kiptui and Kipyegon (2008) did a cointergration analysis to analyze the
impact of external shocks on the real exchange rate in Kenya. From error and correction
estimates, they discovered from their findings that real exchange rates are significantly
affected by oil prices. Major upticks in oil prices were seen to cause deprecation of the
exchange rates both in the short and long term. On top of that, their findings also proved that
domestic shocks also play a significant role in determining the exchange rate. One major
finding was that interest rate differentials do have significant effects on the exchange rate.
Also while government expenditure has positive effects on the exchange rates in both short,
medium and long term, GDP growth has positive effects in the short term and negative
effects in the long term on the exchange rate.
Cheng (2006) started to investigate the monetary transmission mechanism in Kenya by
investigating how the Central Bank of Kenya’s REPO rate affects real output, prices and
nominal effective exchange rate. The study used the VaR technique to churn through and
analyze monthly data from 1997-2005. The study found out that an exogenous increase in the
central bank’s repo rate is almost always followed by a fall in prices and appreciation of the
nominal exchange rate but no significant effect on the output. The study concluded that the
slow response of output to monetary shocks is because the financial system of the country
Kenya has a problem of structural weakness therefore limiting monetary shocks transmission
to the real economy. This study however did not focus on the effect of monetary policy on the
real exchange rate.
Sek et al (2012) did an analysis using the GARCH model on the relationship between
exchange rate flexibility and monetary policy of inflation targeting. The results showed
several correlations but there was a significant correlation between exchange rate fluctuations
and Inflation output movements. They did conclude that monetary policies of inflation
targeting have significant effects on inflation, output and the exchange rate. Upon comparing
this inflation targeting performance in different countries it was observed that exchange rate
volatility is more in Asia compared to developed countries.
Canetti and Greene (2000) studied some African countries to test the existence of a causal
relationship between money supply growth or exchange rate depreciation and inflation. The
countries studied were, Kenya, Gambia, Ghana, Somalia, Sierra Leone, Nigeria, Zambia,
Tanzania, Uganda and Zaire. Both VaR and Granger causality tests were used. After an
experimental exercise the minimum lag length of four was set. In the VaR method, they
established that in four of the ten countries, changes in money supply heavily affected
inflation rates, in three of the other countries, inflation rates were mainly affected by
depreciation of the exchange rates while the remaining three countries showed the effect of
each on the other was mostly equal. They found out that the effect of inflation on the
exchange rate and the effect of money supply on inflation were unidirectional.
2.5 Summary of literature review.
This section explored the theories of purchasing power parity, law of one price and interest
rates parity. purchasing power parity (PPP) suggests that exchange rates should adjust to
equalize the prices of identical goods in different countries, but empirical evidence often
shows deviations. The law of one price posits that identical goods should have the same price
when expressed in a common currency, but various factors, such as transportation costs,
hinder perfect convergence. Interest rate parity theory argues that interest rate differentials
between countries should be offset by exchange rate movements, yet real-world complexities,
such as transaction costs, impact this relationship. Overall, while these theories provide
theoretical frameworks, discrepancies persist in real-world applications, prompting ongoing
research and debate.

References
Purchasing Power Parity. (n.d.). Fx.sauder.ubc.ca. https://fx.sauder.ubc.ca/PPP.html

Purchasing power parity: understanding exchange rates and inflation. (2023, July 15).

Www.lpcentre.com. https://www.lpcentre.com/articles/purchasing-power-parity-

understanding-exchange-rates-and-inflation

. Feenstra, R. C., & Taylor, A. M. (2019). International economics (4th ed.). W.W. Norton &
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Cheng, C.K. (2006). A VAR analysis of Kenya‟s monetary policy transmission mechanism:

How does the Central Bank‟s repo rate affect the economy? IMF Working Paper

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Canetti, E. & Green, J. (2000).Monetary growth, exchange rate depreciation as causes of

inflation in African countries. World Bank WP, 2000

Kiptui, M. &Kipyegon, L. (2008).External shocks and Real Exchange Rate Movements in

Kenya. Central Bank of Kenya

Kandil, A. (2007). Estimating renminbi (RMB) equilibrium exchange rate, Journal of Policy

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Cavallo, M. et al. 2005. Exchange Rate Overshooting and costs of floating. Working paper

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Sek, S.K., Ooi, C.P., & Ismail, M.T. (2012).Investigating the relationship between Exchange

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Anne Kamau and Rose W. Ngugi (n.d.). Exchange rate response to policy news in Kenya.

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