Selected macroeconomic determinants of inflation in Kenya

Abstract

Despite an improved macroeconomic performance in Kenya for nearly a decade, inflation rates have averaged a double digit in recent past. A sharp increase in inflation could reduce the rate of economic growth and worsen poverty levels. High and volatile inflation is a threat to good economic performance. Economic growth took off in 2004 in Kenya, but alongside higher growth, there has been rapid inflation and large inflation volatility. In 2011, the country faced substantial inflationary pressure that was exacerbated by high international oil prices, drought conditions and exchange rate depreciation. As a result, the rate of inflation increased to 19.72 per cent in November 2011, prompting the Central Bank of Kenya to adopt a tight monetary stance. Despite the tight monetary stance and improved economic growth rate during the second quarter of 2012, inflation peaked at over 20 per cent. The study thus sought to establish the determinants of inflation in Kenya. Specifically the study focused on the effect of unemployment, narrow money supply, wide money supply and level of GDP on inflation in Kenya. The hypotheses tested under this study were that unemployment, narrow money supply, wide money supply and level of GDP did not determine inflation in Kenya. The study sought to provide an empirical groundwork on Kenya’s inflation trends upon which prudent monetary and fiscal policies would be formulated. It sought to identify the determinants of inflation, which when properly understood, documented and captured in relevant models would make it possible to estimate accurately the inflation levels within a specified period of time. The study relied on secondary annual time series data of 1980 to 2011. The sources of the secondary data were the Kenya Bureau of Statistics and World Bank. The study employed the use of a Vector Autoregression (VAR) model due to its robustness in forecasting. The collected data was first subjected to unit root test at levels using Augmented Dickey Fuller, Kwiatkowski–Phillips–Schmidt–Shin (KPSS) and Philips Perron methods. The data was found to be non stationary at level but stationary at first difference. The data was then tested for cointegration using Johansen procedure. Modeled variables were found to have long term relation. The Vector Error Correction Model (VECM) was used to determine short term relations among the variables. It was established that GDP and unemployment had a negative impact on inflation while narrow money supply had a positive effect on inflation both on the short run and long run. It was equally established that broad money supply had a negative effect on inflation. Modeled variables passed stability test as well as diagnostic tests thus were fit for analysis. Study highly recommends that the government should use broad money supply (M2) to control inflation and unemployment.