International Journal of Business and Social Science

ISSN 2219-1933 (Print), 2219-6021 (Online) DOI: 10.30845/ijbss

The Relationship among Real Exchange Rate, Current Account Balance and Real Income in Kenya
Boniface Muriithi Wanjau

Persistent current account deficit is a chronic problem in many developing countries including Kenya. In an attempt to understand disequilibria dynamics in Kenya, this study sought to investigate the effect of real exchange on current account balance and additionally investigate whether the rate of import growth in Kenya is consistent to balanced economic growth as stipulated in Thirlwall law. The study is based on two main theories, the neoclassical elasticity approach and balance of payment constraint model. The former contend that balance of payment is influenced by the nature of import and export elasticities, while the later theory holds that long run economic growth rate may be achieved if growth of export is consistent with import growth rate. Informed by aforementioned theories, two main objectives were investigated: First was to determine the effect of real exchange rate change on current account balance in Kenya. Secondly was to determine the extent to which import growth rate is consistent with balanced economic growth in Kenya. The first objective was tested by regressing the trade balance against real exchange rate, foreign income and relative prices, degree of openness and government expenditure. The significance and signage of real exchange rate coefficient was used to determine whether Marshal-Lerner condition holds. To test the second objective, elasticity of income was estimated using an import function and compared to the theoretical income elasticity proposed in the balance of payment constraint model. Annual time series data from 1980 to 2011was modeled using ARDL model. The data were subjected to Stationarity test using Augmented Dickey Fuller (ADF) test and Phillip Perron test. Co-integration and Error correction model was applied to analyze short run and long run dynamic. The model was subjected to heteroskedasticity test and serial correlation test and an appropriate model used in the estimation. Student t test and Wald test were used to test for significance and compare hypothesized coefficient respectively. The results showed that Marshal-Lerner-Conditions hold in Kenya and the J-curve phenomena is supported by data. Secondly import growth rate is significantly higher than the level consistent with long run growth of the economy. One of the recommendations is to introduce policies that will trigger increase in demand for export and thereby drive the economy towards sustainable growth and development.

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