Determinants of exchange rate volatility in Uganda

Abstract

This study examined the determinants of exchange rate volatility in Uganda using monthly data spanning the period January 2000 to June 2025. Employing the Autoregressive Conditional Heteroskedasticity (ARCH) family model with multiplicative heteroskedasticity, the study analyzed both the mean and variance equations to capture the dynamic behavior of the Ugandan shilling against the U.S. dollar. The results from the mean equation revealed that interest rates exert a statistically significant negative effect on the exchange rate, implying that a 1% increase in interest rates leads to an approximate 0.13% appreciation of the Ugandan shilling. This finding underscores the critical role of monetary policy in influencing exchange rate movements in Uganda. In the variance equation, the results demonstrated that inflation and the trade balance significantly reduce exchange rate volatility. Specifically, higher inflation rates were associated with lower levels of volatility, suggesting that price stability contributes to currency stability when supported by consistent policy frameworks. Similarly, an improved trade balance was found to stabilize the exchange rate by reducing external sector imbalances. The ARCH component indicated that recent exchange rate shocks have a strong and immediate effect on current volatility, while the GARCH term showed that such volatility tends to dissipate relatively quickly thus short lived nature of market disturbances. The findings overall suggest that Uganda’s exchange rate dynamics are largely influenced by interest rate policy, inflation management, and trade performance. Several policy implications emerge. The Bank of Uganda should strengthen its monetary policy stance through strategic interest rate adjustments to mitigate exchange rate fluctuations during periods of depreciation pressure. The government should also sustain price stability by maintaining credible inflation targeting frameworks, stabilizing food and fuel prices, and controlling cost-push inflation sources. Enhancing the trade balance through export promotion, diversification into high-value sectors, and investment in trade infrastructure can further stabilize the currency. Finally, coordination between fiscal and monetary policies is critical to ensure policy consistency, promote macroeconomic stability, and prevent conflicting outcomes.