Chapter two: LITERATURE REVIEW
2.1 Introduction
In this chapter, both the theoretical and empirical literature were reviewed which were related to the
field of study and to understand the relationship between movements of exchange rates and their impact on
inflation.
2.1.1 Exchange Rate
An exchange rate is a price exactly the same as any other price of the amount you have to
give up to acquire something else, in this case, another currency. Consequently, an exchange
rate is the price of one currency in terms of another. In other words, it is the price you will pay
in one currency to get hold of another. The price can be set in various ways. It may be fixed by
the government or it could perhaps be linked to something external - for example, gold.
However, the most likely alternative is that it will be fixed in the market. Since it is a price, it will
be determined, like any other price, by demand and supply. A high level of demand for a
currency will force up its price, which is the exchange rate. Where supply is equal to demand is
the equilibrium exchange rate. An exchange rate is expected to have a negative sign. This is
because the exchange rate has a direct impact on the price of exports and imports in a country.
Thus, if the nominal exchange rate of a country depreciates, inflation will increase. This is
expected to have a negative sign (Sowa & Kwakye, 1993).
2.1.2 Inflation Rate
This refers to an annual increase in the price of a basket of goods and services that are
purchased by consumers in an economy leading to the decline of the purchasing power of a
country’s currency. In other words, it is a rate at which the currency is being devalued causing
the general prices of consumer goods to increase and this is relative to a change in currency
value. The usual approximate measure of this is the Consumer Price Index (CPI) which weighs
the prices of different goods according to importance in a typical budget, and then to see how
much the prices of these goods have increased. This immediately raises some problems. For
example, the weighting must change over time (Akhiria & Saliu, 2008).
2.2 Empirical Literature Review
Durevall and Ndung’u (2001) in their paper on inflation in Kenya assert that inflation
emanates from cost-push factors due to currency devaluation, demand-pull forces where
excessive credit expansion causes excess demand, the balance of payments crisis, and
controlled prices which deviate from market prices causing shocks. They observe that the
monetary base, exchange rate, real income growth, and interest rate have an effect on the rate
of inflation in a country. They concluded that exchange rate is more important than monetary
factors in explaining the inflationary process in Kenya and that inflation and money supply leads
to the depreciation of the nominal exchange rates.
Okhiria and Saliu (2008) examined the impact of exchange rate on the inflation rate and
the relationship that exist among government expenditure, money supply exchange rate, oil
revenue, and inflation in Nigeria. The study adopted the Augmented Dickey-Fuller to carry out
the unit root test and cointegration with Johansen test. The study found out that measures
employed by the government to reduce the amount of money supply, government
expenditure, and control measure on the exchange rate could lead to poor productivity in the
country. The study concluded by recommending that policymakers should try to cushion the
effect of inflation on the economy when the need arises so that rise in the exchange rate will
not lead to inflationary pressure in the short run. Even though inflation and exchange rate have
no long-term relationship, short term relationship seems to exist.
Kirimi (2014) also investigated the main determinants of inflation in Kenya from 1970-2013
and estimated the time series data using ordinary least squares. More specifically, the study
demonstrates that the central bank rates and GDP growth rate are significant determinants of
inflation rate during the period. According to the result, food price, GDP growth rate, and the
corruption perception had a negative relationship with inflation, while money supply (M2) and
exchange rate had a positive relationship with the inflation rate. Central bank rates were also
found to be statistically significant at a 5% significance level in causing the variation in the
inflation rate. However, wage rate was found insignificant in causing the changes in inflation
with political instability having no effect on inflation.
Egwaikhide et al. (1994) in their studies of the impact of exchange rate on inflation and
budget deficit in Nigeria used annual data from 1973–1989 by using co-integration and EECM
models. They used inflation, revenue, and exchange rate equations to analyze the impacts of
exchange rate on inflation and budget deficit. The results from the inflation equation show that
the official exchange rate is the main determinants of inflation. Egwaikhide et al. concluded that
the official exchange rate in Nigeria is the main determinant of inflation and budget deficits.
