Determinants of exchange rate volatility in Uganda.

Abstract

Exchange rate volatility remains a persistent challenge for Uganda's commodity-dependent economy, affecting trade, investment, and macroeconomic stability under the Bank of Uganda's flexible exchange rate system. This study looks at the factors that affect the volatility of the USD/UGX exchange rate between 2010 and 2024. It focuses on monetary factors (money supply and money demand as measured by GDP and interest rates), external factors (trade balance and foreign direct investment), and the moderating effect of foreign exchange reserves. The study uses descriptive statistics, correlation analysis, GARCH (1,1) modeling to estimate conditional volatility, and multiple linear regression to evaluate the determinants of volatility using annual time-series data from the Bank of Uganda, World Bank, and IMF. Compared to the widespread belief of growing instability, the results show a steady decrease in exchange rate volatility from 2012 to 2024. While foreign direct investment inflows exhibit a considerable positive correlation with volatility, economic growth (GDP) has a strong, significant negative influence. This is probably because of shortterm pressures from big, irregular capital flows, particularly those related to oil. In the multivariate model, the money supply, interest rates, trade balance, and reserves all show negligible effects; nonetheless, reserves seem to support long-term stabilization through better fundamentals and policy credibility. Multiple regression reveals that real GDP exerts a strong, significant negative effect on volatility (β = −1.54 × 10⁻⁵, p < 0.05), suggesting that sustained economic growth substantially reduces exchange rate fluctuations. FDI inflows display a significant positive association (β = 2.63 × 10⁻⁴, p < 0.05), consistent with shortterm currency pressures from large, irregular capital flows (particularly oil-related). Money supply (M2), interest rates, trade balance, and reserves show insignificant coefficients in the multivariate model (all p > 0.05), though reserves likely support long-run stability through enhanced policy credibility and import cover.