Using Bayesian vector auto-regression methodology, we empirically analyze the dynamic responses of the exchange rate to sudden changes in net short term capital inflows, among other economic factors, in Kenya. Based on impulse response results, we find, rather surprisingly, that a sudden increase in net short term capital inflows immediately induces a depreciating effect which increases during the first two quarters upon which a correction ensues whereby the exchange rate appreciates for 4 quarters after which the effect dies off. We believe that the sudden net short term capital inflows are initially monetized thereby becoming a domestic nominal shock which causes a Dornbusch-like exchange rate overshooting. We also find that a sudden increase in interest rate differentials immediately causes an appreciating effect which dies off within a year. Furthermore, a sudden increase in interest rate differentials immediately attracts net short term capital inflows followed by persistent capital reversals within 2 quarters. The variance decomposition results show that, 71.4% of the one quarter-ahead and 54.2% of the four quarters-ahead exchange rate forecast errors are accounted for by the interest rate differentials. Net short term capital inflows' share in the one quarter ahead exchange rate forecast error is a mere 0.1%. At its best, it accounts for only 6.8% of the seven-to-eight quarters ahead exchange rate forecast errors. These results suggest that net short term capital inflows play a relatively limited role compared to interest rate differentials in determination of exchange rates dynamics in Kenya.
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