Effects of the Real Exchange Rate on the Trade Balance in Kenya

The trade balance is one of the main components of the current account bal-ance and hence the balance of payment. This study established the long run relationship between the real exchange rate and the trade balance in Kenya us-ing annual time series data from 1963 to 2013. Also, the real exchange rate had a positive and significant effect on both the long run period and the short run adjustment mechanisms on trade balance. Therefore, depreciation of the real exchange rate affects trade balance in the long run, even though the deficit continues but depreciation may have played a role to manage the decline. This study adopted the two-country imperfect substitute model of Rose and Yellen (1989) which analyses the relationship of the real exchange rate and the trade balance. The model also incorporates the elasticity, absorption and monetary approaches by simultaneously considering the real exchange rate, domestic and foreign income, money supply and exchange rate regime. The approach as-sumes that there is a linkage between the real exchange rate and the trade bal-ance. Studies in both developed and developing countries show different re-sults on the relationship of the real exchange rate on the trade balance. This study applied Cointegration Vector Autoregressive and Vector Error Correc-tion modelling and established the relationship and the effects of the real ex-change rate and other variables on the trade balance. The exchange rate regime had no effect on the trade balance. Policy makers thus need to ensure the sta-bility and competitiveness of the real exchange rate for favourable trade bal-ance in Kenya.