The forecasting equation for the exchange rate between the Kenya shilling and the US dollar is given by:
Yt = a + b1tX1t +b2tX2t +e
Where Yt is the direct quote for the period t
X1t is the inflation rate differential between Kenya and the US for the period t
X2t is the interest rate differential between Kenya and the US for the period t
Assume historical data has been collected and presented as follows:
MONTH INFLATION RATE INTEREST RATE EXCHANGE RATE
DIFFERENTIAL DIFFERENTIAL
1 12 4.5 84
2 10 6.0 97
3 15 3.5 92
4 16 3.8 90
5 11 2.9 89
6 9 3.0 90
7 14 4.2 96
a) Using the multiple linear regression method, develop a forecasting model for the exchange rate
b) Determine the reliability of the function established in (a) above
c) Determine the exchange rate between the Kenya Shilling and the Dollar if the inflation rate is
expected to be 25% in Kenya and 7% in the US while the interest rate is expected to be 13% in
Kenya and 7.2% in the US