The effect of exchange rate policy on the economic development of Kenya

Abstract

This dissertation attempts to assess the negative effect that the Kenyan government's exchange rate policy had on aggregate output and on sectoral composition of output. The Kenyan government chose a macroeconomic policy set in order to achieve certain economic, political, and social goals as part of its development objectives. The policy mix included industrialization policies, a expansionary monetary policy, a pegged exchange rate, and other policies that created a bias against the agricultural sectors. An empirical macroeconomic model was constructed to capture the economic processes that cause equilibirium exchange rate fluctuations. The exchange rate is determined by Kenya's price level relative to the rest of the world and by Kenya's productivity relative to the rest of the world. Exogenous events and government policies that affect the price level and productivity will influence the exchange rate as well. A model of equilibrium exchange rate movements can then be used to assess exchange rate misalignment: ' i.e.', when the exchange rate undervalues or overvalues the domestic currency relative to foreign currency. Given a calibrated model for Kenya's macroeconomy, a simulation was used to compare Kenya's actual experience with a counter-factual exchange rate policy that produces no relative price distortions. The results indicate, among other effects, that a floating exchange rate policy would have led to higher total output compared to the exechange rate policy that Kenya actually pursued.