Exchange rate volatility and macroeconomic performance : evidence from East African countries
Amito, Christine Hellen
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Developing countries operating a flexible exchange rate regime, without exception, experience disruptive volatility in the exchange rates. The existing empirical evidence reveals that fluctuations in exchange rates can potentially generate distortions in the economy. Although macroeconomic performance has improved after the reforms, economies are still confronted with series challenges including persistent trade deficits and inflation, leading to macroeconomic instability. The causes and effects of exchange rate fluctuation on the macroeconomy has been a subject of interest among economists and policy makers. However, the insufficient empirical evidence on EACs exists. Thus, this study aims to contribute to the empirical literature and debate on the behavior of exchange rates and its effects on the macroeconomic performance in the East African countries. The specific issues addressed include to model exchange rate characteristic, assess the determinants of exchange rate fluctuations, and examine the effects of exchange rate volatility on international trade and economic growth. Various methods including the descriptive method, generalized autoregressive conditional heteroskedasticity, Johannsen cointegration and panel vector error correction approaches are employed in the analysis of the data used in this study. The study comprises of four empirical studies. The bilateral exchange rate against the US dollar using monthly data for the period January 1995 to December 2016 is used, results suggest that exchange rate volatility is characterized by conditional volatility, implying that its quite persistent and exhibits volatility clustering. The causes and effects of exchange rate volatility, annual time series data for the period 1995 to 2016 are used. The results show the existence of a long run stable relationship among variables. The study finds that a positive influence of money supply on a long run effect of exchange rate volatility. The results show that real gross domestic product, trade openness and foreign exchange reserves have a negative long run effect on exchange rate volatility in the EACs. The study findings show that exchange rate volatility has a long run negative effect on international trade and economic growth of the EACs. The implication is that exchange rate volatility increases the degree of risk aversion of traders, which results in the reduction of trade and economic growth. The other key determinants of international trade are income and relative prices. As for economic growth, other determinants show that government expenditure and inflation have negative long run effect while gross fixed capital formation, financial development, trade openness and money supply have long run positive effect on economic growth. In summary, adoption of flexible exchange rate systems introduced a series of fluctuations in the exchange rates. For small open economies that heavily rely on imported goods, such fluctuations may affect domestic prices and overall macroeconomic stability. In addition, with widening gap between exports and imports that has led to worsening trade deficits, has implications for economic growth. The policy implications, suggest the need for policy makers to stabilise exchange rate volatility while focusing on the factors that cause exchange rate volatility. Exchange rate volatility plays a key part in international trade and economic growth, thus trade activities and economic growth in these countries can be improved further with the aim to maintain a stable exchange rate system. The need to pursue measures that would contribute to increased productivity and the enhancement of international competitiveness through diversification of the export sector and trade policies that encourage exportation. The findings of the study show that it is important for monetary authorities to ensure that the exchange rate is always at an appropriate level to avoid the negative implications of exchange rate volatility on international trade and economic growth.