Macroeconomic drivers of exchange rate volatility in Uganda: an empirical analysis using Arch and Garch models

Abstract

The main purpose of this study was to examine the macroeconomic drivers of exchange rate volatility in Uganda. In particular, the study sought to find out if there exists an ARCH-LM effect in Uganda’s exchange rate for the sample period 2000-2020; investigate the macroeconomic factors responsible for exchange rate volatility in Uganda for 2000-2020 and to find out whether there’s a difference in measuring exchange rate volatility between ARCH and GARCH models. Knowledge of volatility is of crucial importance to importers, exporters, and traders in foreign exchange markets, for variability in the exchange rates means huge losses or profits. Monthly data series spanning 19 years and up to 263 observations for each time series variable were chosen. Macroeconomic factors such as money supply (M3), Private Sector Credit (US$ millions), Composite Index Economic Activity (CIEA), Private Demand Deposit (US$ millions), Trade balance (US$ millions) and Gross foreign exchange reserves (US$ millions) were selected in this study. The Pearson correlation tested for pairwise correlation, ARCH-LM tested for volatility clustering, AIC, BIC, SIC, HQIC were for suitable model selection while the ARCH-GARCH model was for detecting volatility in the Uganda’s exchange rate. The findings revealed that whereas increases in private sector credit, trade balance, composite index of economic activity, and money supply raise the country's exchange rate volatility, private demand deposits and gross foreign currency reserves minimize it. To lower Uganda's currency rate volatility, the government must raise private sector financing, eliminate non-productive economic activity, improve the balance of trade, reduce money supply, and increase gross foreign exchange reserves and private demand deposits.