Monetary policy, exchange rate flexibility and output stabilization in East African economies: a Mundell–Fleming analysis

This study uses the Mundell–Fleming model to examine how exchange rate volatility and capital mobility influence the transmission of monetary and fiscal policies to real output in Kenya, Rwanda, Tanzania, and Uganda from 1996 to 2024. Using World Bank data, it employs a Two-Way Fixed Effects model with interactions as the baseline, alongside a Panel ARDL model in error-correction form to differentiate short- and long-term effects. Empirical results show real interest rates negatively impact GDP per capita growth (−0.0816), confirming a functional interest-rate channel. Its effectiveness depends on context: exchange rate flexibility (RINT x ERvol) has a positive, offsetting effect (0.0201), suggesting that flexible regimes boost policy through expenditure switching. Higher capital mobility (RINT x FDI) also significantly affects transmission (0.054), showing financial integration changes output sensitivity to interest rate shocks. The Panel ARDL reveals a high speed of adjustment to the long-run equilibrium (−0.866), though the short run is characterized by a ‘Fear of Floating’. The study concludes that the EAC countries face a policy ‘dilemma’ rather than a traditional trilemma, as global financial cycles increasingly dictate the efficacy of domestic policy. Policy efforts should therefore address structural rigidities and manage flexibility to stabilize output.