Final Term Paper 3

7/30/2019 Final Term Paper 3

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Studying the Relation Between, Interest Rate and Inflation Rate Based

On Fischer International Theory and its effect in Kenyan Economy

Abstract

The aim of this research is to study the relation between, interest rate and inflation rate based on

Fischer international theory. The study is an attempt to find a relation betweenthe change in the interest rates and inflation and its effect in the Kenyan economy. Participants

in the Kenyan economy seen through the stock markets and consumer pricing indices believe

that the interest rates have a bearing on the behavior of inflation. This popular perception is put

to test in the following research by correlating the change in the interest rates and inflation instock market and consumer pricing index. Empirical data has been collected from Kenya Bureau

of statistics. Subjected to correlation analysis to find out the significance of these parameters.

The monthly interest rates, consumer price index, number of transactions , number of sharestraded, foreign exchange rates and reserves has been collected for the last one year. The

correlation between the change in interest rates and inflation is calculated for each month

contracts of these factors.


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CHAPTER ONE

INTRODUCTION

The issues regarding currency rate, interest rate and inflation rate are among main issues of

policy making in developing counties. Currency rate is considered as such a key economic

variable in policy making that some experts in developing countries name it a nominal anchor.

Exchange rate is highly affected by financial factors particularly interest rate. Many researchers

believe that interest rate affects currency rate. Currency determines commercial trend, inflation,

capital flows and foreign investment inflation, savings, and international payments in an

economy (Aziz 2008). When stock holders attack the currency of a country, of a country,

controlling currency rateeven under government protection- may be highly expensive and even

useless. High interest rate prevents capital return and economic growth, and finally damages the

economy. (Solnik 2000) several factors influence variation of currency rate including changes in

foreign demand and supply, amount of payment problems, inflation growth, interest rate,


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In other words, high interest rate persuades them to lend their surplus liquidity to others.

However, it should be mentioned that in balances states, interest rate is balanced with supply

(Investment) and demand (saving) in capital market (Duetsche Bundesbank 2001). Fischer

international effect theory states that foreign exchanges with relatively high interest rate will

move toward lower prices because high nominal interest rate reveals expected inflation rate

(Madura 2000). This theory also shows that changes in spot exchanges rate between 2 countries

will move toward same changes in nominal interest rate (Demirag and Goddard 1994). It is very

important for economic policy makers to answer this question: whats the relation between

currency rate and interest rate, and how does interest rate react occurred fluctuation in currency

rate?

Regarding changes in currency rate, interest rate and inflation, Fischer international effect theory

states that prospective currency rate can be determined by changes in nominal interest rate.

Changes in predicted inflation within nominal interest rate is expected to influence cash currency

rate in future (Sundqvist 2002).Aust. J. Basic & Appl. Sci., 5(12): 1371-1378, 2011-1372.


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CHAPTER TWO

LITERATURE REVIEW

2.0 THEORETICAL BACKGROUND

For many years money has been a central issue in monetary policy making. Central banks

used to set monetary targets and academics used to teach monetary policy, as a story about

how central bankers adjusts the money supply. Even the name of the main activity of central

banks took its origins from the word money. However, the world is changing, and targeting

monetary aggregates becomes less and less fashionable. The main reason is probably the

growing instability of money demand functions, A. Blinder (1998).

In reaction, monetary authorities move from targeting the money supply towards controlling

nominal interest rates at the money market. As a result, in the recent decade, a huge amount of

papers, describing monetary policy rules based on nominal interest rates, has been written. As

it is, however, well known, assuming there is no money illusion, it is in fact the real and not

the nominal interest rate, that can influence spending decisions of enterprises and households.


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resulting from the central bank.s influence on the real rate of interest (T.M.Humphrey 1993).

Nevertheless, not much has been done in this field since. Recent papers, among others by

M.Woodford (1999, 2000), revived the (now called) Wicksellian idea of inflationary

processes being determined by the gap between the real and natural3 rates of interest. In a very

recent study K.Neiss and E.Nelson (2001) use a stochastic general equilibrium model to

examine the properties of the interest rate gap as an inflation indicator. The above mentioned

studies are strongly in favour of using the gap as a measure of the stance of monetary policy

that could be used by central bankers in their day-to-day (or rather month-to-month) policy

setting.

2.1 LITERATURE REVIEW

The basic puzzle about the so-called Fisher effect, in which movements in short-term

interest rates primarily reflect fluctuations in expected inflation, is why a strong Fisher


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The evidence here can explain why the Fisher effect appears to be strong only for particular

sample periods, but not for others. The conclusion that there is a long-run Fisher effect

implies that when inflation and interest rates exhibit trends, these two series will trend

together and thus there will be a strong correlation between inflation and interest rates. On

the other hand, the nonexistence of a short-run Fisher effect implies that when either

inflation and interest rates do not display trends, there is no long-run Fisher effect to

produce a strong correlation between interest rates and inflation. The analysis in this paper

resolves an important puzzle about when the Fisher effect appears in the data. Nber

working paper No. 3632 ( Also Reprint No. r1786) Issued in May 1993 NBER Proram.

2.2 THEORETICAL CONCEPTS

2.2.1FISCHER INTERNATIONAL THEORYFischer International Theory explain the relation between interest rate changes between 2

countries and expected changes in currency rate. According to this theory, the real output of the

investors in local stock market is the same as foreign interest rate and making change in the


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Therefore, Fischer international Effect Theory suggests that foreign currency market E(r) should

be equal with interest rate of investment in local money market (ih). Since in average, efficient

output in a foreign investment should be equal with efficient output in a local investment,

therefore:

E(r)= ih

To provide investment opportunities either locally or globally, and to obtain similar interest rate,

r should be adopted by ih and foreign currency should change in order that ih=r. therefore, 1-

(1+ef)(1+if)=ih

r= real output of foreign deposit,

ih= interest rate internal deposit

ih is presented as follows to show the value of foreign currency (ef). Finally the function of IFE

theory . It can be concluded that when local interest rate is lower than foreign interest rate, the

value of foreign currency will decrease because the exceeding of foreign interest rate from local

one will cause collapse in the value of foreign currency. (Utami, Inanga 2009).

Currency Rate:


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Fischer Effect Theory:

Fischer believe that real interest rate is apart from monetary frames. Fischer equation is as

follows:

e

rr rn

Where:

rn= nominal interest rate, e = expected inflation rate, rr= real interest rate.

All high interest rate are constant and combined.

However, Fischer applies the following equation for simple rates:

Aust. J. Basic & Appl. Sci., 5(12): 1371-1378, 2011-1373

When rn increases, e also goes up.

Fischer says that nominal interest rate is complied with expected inflation. Researches believe

that any increase in monetary growth rate leads to higher inflation rate, but nothing occurs to real

parameters. Careful application of this principle leads to money influence on interest rate. This


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When there is no gap in interest rate, inflation rate becomes zero and prices are fixed. Brzoza

said that in the time of expanding monetary policies (interest rate r*>r), inflation will occur, and

in contracting monetary policy, prices will decrease (r*


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Interest Rate:

Interest is defined in various ways. The amount which is paid at the time of using capital is

called interest. When the amount of payable interest to the capital is presented in percentage, it is

called interest rate. Fischer states that interest rate is the percentage of payable bonus based the

money on a fixed date. Indeed, interest rate is a kind of charge to be paid for a loan. It is also the

most important and effective factor reinforcing a national currency (Mohammad Masah 2009).

Inflation Rate:

Researches done on developed and some newly appeared economies show that despite the

increase in global price of raw materials such as oil, steel, and making extending monetary

policies in most of countries, the price levels have increased less and inflation rate have been less

than predicted values. In other words theAust. J. Basic & Appl. Sci., 5(12): 1371-1378, 2011

1374 common models of predicting inflation have been estimated more than their real situation

(Tayebnia & Zandieh 2009).

Many surveys have been done by researchers to identify the reasons for inflation in Iran

economy. All of them concluded that liquidity volume is a main factor in formation of Iran


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Northern American Union during 1991-2005. their findings are divided into 2 following

categories:

- There is a strong relationship between inflation and real currency rate in Asian Countries but

this rate drastically in European and North American Union.

- Asian financial crisis seems to have local effect, but they havent had a significant effect on

currency rate in European and North American union. The results emphasize on the significance

of managing inflation as an economic factor. Utami and Inanga (2009) studied the relation

between currency/interest/inflation rates in Indonesia. They studied various interest rate on

currency rate base on Fischer International Effect Theory, and inflation rate on interest rate based

on Fischer effect theory, and compared America, Japan, England, Singapore with Indonesia

(as a home land) during 2003-2008. they concluded that Fischer international effect theory is

effective for that but it is not remarkable for England, Singapore and America. Also interest rate

changes have a very negative effect on currency rate changes in Japan. Therefore Fischer effect

theory does not work in Japan because when local interest rate is higher than international one,


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article to investigate economic status of Turkey during 1984-2003 by applying monthly

observations and frequency percentage. The results showed a relation between nominal

interest rate and inflation rate in a unique and guided way, interest rate nominal interest rate

determines future path of inflation. Masao Ogaki and Julio Santaella (2005) empirically studied

the effects of interest rate on currency rate in Mexico and found that 1-month and 3-month

interest rate fluctuation in Mexico has a reverse effect on currency rate.


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CHAPTER THREE

METHODOLOGY

The existing research is an applied one in views of objective, and regressive in view of function.

Inductive method is also used in this research. So that to test the research hypothesis, some

annual data are applied and after testing, their results are studied by confirming or rejecting the

hypothesis. Moreover, the findings can be generated to the whole statistical society. To test the

research hypothesis, econometric methods are applied, and SSPS software is used for data

analysis.

Statistical Society:

The statistical society of this study is Kenyan economy. We applied our considered data and

statistics to find the relation between interest rate and inflation with the help of Fischer

international effect theory and Fischer effect theory. Then the tests are studied according to

Kenyan economy.

Sample Volume:

This research is done regarding the objectives of Kenyan economy. The entire statistical society


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CHAPTER FOUR

DISCUSSION AND CONCLUSION:

The main objective of this research is to answer this question: is there a relation between

interest rate and inflation in Kenyan economy based on Fischer international theory

economy based on Fischer international effect theory?

Inflation is a function of average yield rate of 91 - day treasury bill, the rate for commercial banks loans

and advances (weighted average), overdraft rates, inter-bank rates, savings (commercial bank rates)

Let I = National Inflation Rate

T = Average yield rate of 91 - day Treasury bill

R = The rate for commercial banks loans and advances (weighted average)

O = Overdraft Rates

r = Inter-bank rates

S = Savings (commercial bank rates)

( , , , , )I f T R O r S

Therefore:


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AVERAGE YIELD RATE 91 -

DAY TREASURY BILL 0.778571 0.1606 1.569626 4.847905 0.000673

RATE FOR COMMERCIAL

BANKS LOANS AND

ADVANCES (WEIGHTED

AVERAGE) -0.89727 0.347938 -0.83496 -2.57883 0.027472

3 (Constant) 18.45336 5.097597 3.620012 0.005572



RATE FOR COMMERCIAL

BANKS LOANS AND

ADVANCES (WEIGHTED

AVERAGE) 1.136226 2.342466 1.057316 0.485055 0.639225

OVERDRAFT RATES -1.87054 2.130283 -1.89467 -0.87807 0.402737

4 (Constant) 23.35847 4.287526 5.448006 0.00061



RATE FOR COMMERCIAL

BANKS LOANS AND

ADVANCES (WEIGHTED

AVERAGE) -0.39696 1.874772 -0.36939 -0.21174 0.837606OVERDRAFT RATES -0.71436 1.680839 -0.72357 -0.425 0.682038

INTER-BANK RATES 0.227525 0.083423 0.631361 2.727376 0.025951

5 (Constant) 29.23127 4.764346 6.135422 0.000474



RATE FOR COMMERCIAL

BANKS LOANS AND

ADVANCES (WEIGHTEDAVERAGE) 0.167384 1.63944 0.155759 0.102098 0.921542

OVERDRAFT RATES -0.3511 1.458698 -0.35563 -0.24069 0.81669

INTER-BANK RATES 0.130478 0.08738 0.362065 1.493223 0.179017


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Table 2: Model Summary

MODEL SUMMARYModel R R Square Adjusted R Square Std. Error of the Estimate

1 0.817974 0.669082 0.638998 1.840568

2 0.895128 0.801254 0.761505 1.496017

3 0.903846 0.816937 0.755916 1.513446

4 0.951388 0.90514 0.85771 1.155539

5 0.968766 0.938508 0.894585 0.994602

ANOVA(f)

Model Sum of Squares df Mean Square F Sig.1 Regression 75.35 1 75.35 22.24 0.00

Residual 37.26 11 3.39

Total 112.61 12

2 Regression 90.23 2 45.11 20.16 0.00

Residual 22.38 10 2.24

Total 112.61 12

3 Regression 92.00 3 30.67 13.39 0.00Residual 20.61 9 2.29

Total 112.61 12

4 R i 101 93 4 25 48 19 08 0 00


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loans and advances (weighted average) is raised by a unit, inflation goes up by 0.16. Conversely, if

overdraft rate was increased by 1 unit, the inflation rate reduces by 0.36 as opposed to interbank lending

rate which would lead to increase in inflation rate by 0.36. The results finally reveals that, the more the

savings at commercial bank rates, the less the inflation (that is, an increase in the savings at commercial

banks rate by 1 unit would lead to decrease in inflation by 0.6 units.

Further analysis (see Table 2) indicates the five explanatory variables (i.e. average yield rate of 91 - day

treasury bill, the rate for commercial banks loans and advances (weighted average), overdraft rates, inter-

bank rates as well as savings (commercial bank rates)) collectively explain 93.85% of any change in the

inflation. The remaining 6.15% is explained by other variables (intervening variables) that are not

captured in the model.

The results from the tests show 2 general items:

1- There is negative and reverse relation between interest rate and currency rate.

2- There is a direct and positive relation between inflation rate and interest rate.

According to the results, there is a reverse and negative relation between interest rate and

currency rate. So, increased interest rate will cause decreased currency rate. It should be


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research acknowledge it. So, Central decreases interest rate when some inflation indexes reveal a

number of signs of decreasing general prices.

REFERENCES

Alvarez, Fernando and Andrew Atkeson. 1997. Money and Exchange Rates in the Grossman-

Weiss-Rotemberg Model. Journal of Monetary Economics, 40: 619-640.

Alvarez, Fernando, Andrew Atkeson, and Patrick Kehoe. 2000. Money, Interest Rates, and

Exchange Rates with Endogenously Segmented Asset Markets. Federal Reserve Bank

of Minneapolis working paper.

Brock, William A. 1974. Money and Growth: The Case of Long-Run Perfect Foresight.

International Economic Review, 15: 750-777.

Carlstrom, Charles T., and Timothy S. Fuerst. 2000. Forward-Looking Versus Backward-

Looking Taylor Rules. Federal Reserve Bank of Cleveland working paper.


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Rochester Conference Series on Public Policy, 29: 173-203.

Occhino, Filippo. 2000. Heterogeneous Investment Behavior and the Persistence of the

Liquidity Effect. University of Chicago doctoral dissertation.

17

Rotemberg, Julio J. 1984. A Monetary Equilibrium Model with Transactions Costs. Journal

of Political Economy, 92: 40-58.

Sargent, Thomas J., and Neil Wallace. 1981. Some Unpleasant Monetarist Arithmetic.

Federal Reserve Bank of Minneapolis Quarterly Review.

Sidrauski, Miguel. 1967. Rational Choice and Patterns of Growth in a Monetary Economy.

American Economic Review, 57: 534-544.

Svensson, Lars E.O. 1999. Inflation Targeting as a Monetary Policy Rule. Journal of

Monetary Economics, 43: 607-654.

Taylor, John B. 1993. Discretion Versus Policy Rules in Practice. Carnegie-Rochester

Conference Series on Public Policy, 39: 195-214.


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APPENDICES

Appendix I: INTEREST RATES

INTEREST RATES

PERIOD

AVERAGE YIELD

RATE 91 - DAY

TREASURY BILL

RATE FOR

COMMERCIAL BANKS

LOANS AND ADVANCES

(WEIGHTED AVERAGE)

OVERDRAFT

RATES

INTER-

BANK

RATES

SAVINGS

(COMMERCIAL

BANK RATES)

Dec-10 2.28 13.87 13.69 1.16 1.45

Mar-11 2.77 13.69 13.6 1.25 1.37

Apr-11 3.26 13.92 13.68 4.08 1.39

May-11 5.35 13.88 13.72 5.56 1.38

Jun-11 8.95 13.91 13.59 8.3 1.37

Jul-11 8.99 14.13 13.88 8.54 1.37

Aug-11 9.23 14.32 14.28 15.55 1.37

Sep-11 11.93 14.79 14.64 7.4 1.34

Oct-11 14.8 15.21 14.87 14.67 1.33

Nov-11 16.14 18.48 18.56 28.72 1.41

Dec-11 17.9 20.04 20.2 22.14 1.59

Jan-12 20.56 19.54 20.38 19.39 1.62

Feb-12 19.7 20.28 20.53 18.48 1.69

Mar-12 17.8 20.34 20.52 23.77 1.72


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APPENDIX II: INFLATION RATE

Inflation Rates

PERIOD

NAIROBI

LOWERINCOME NAIROBI MIDDLEINCOME

NAIROBI

UPPERINCOME NAIROBICOMBINED

PROVINCES

EXCEPTNAIROBI KENYACPI

Mar'11/Mar'10 11.04 5.35 5.38 9.91 8.99 9.19

Apr'11/Apr'10 14.04 7.55 6.39 12.39 11.92 12.05

May'11/May'10 13.97 8.74 6.18 12.88 13.31 12.95

Jun'11/Jun'10 15.96 9.57 10.14 14.65 14.66 14.49

July'11/July'10 16 10.15 11.67 15.58 16.29 15.53

Aug'11/Aug'10 17.17 11.28 12.92 16.89 17.37 16.65

Sep11/Sep10 17.97 12.42 13.15 17.88 17.91 17.32

Oct11/Oct10 19.58 14.33 14.48 18.77 19.45 18.91

Nov11/Nov10 20.62 15.57 13.99 19.09 20.09 19.72

Dec11/Dec10 20.63 15.75 13.69 18.6 18.73 18.93

Jan12/Jan11 20.27 14.07 11.56 18.49 18.18 18.31

Feb12/Feb11 17.8 13.15 11.09 16.48 16.85 16.7

Mar12/Feb11 16.5 12.56 10.87 15.39 15.77 15.61

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