Modeling the Relationship between Exchange Rate and Balance of Trade Components in Rwanda (2005-2012)

Exchange rate stability affects foreign investments, price stability and stable economic growth. Rwandan currency has depreciated overtime. General objective of this study was to model the relationship between exchange rate and BOT in Rwanda. Specific objectives were to test for the stationarity of exchange rate and BOT components, to determine the relationship between exchange rate and BOT components and to investigate the effects of BOT components on exchange rate in Rwanda. The study utilized monthly time series data from 2005 to 2012 sourced from BNR and NISR. The study carried out ADF and PP unit root tests, Johansen cointegration test, Quantile regression and impulse response function tests. The results of ADF and PP tests revealed partial stationarity at level and full at first difference. Johansen cointegration tests revealed a long run relation exists between exchange rate and BOT components. Quantile regression results revealed positive significant effect of BOT components on exchange rate. The impulse response results also confirmed the same. The study recommends adoption of import reduction strategies and export expansion strategies.