Effects of public debt, trade and monetary policy on inflation in Kenya

Abstract

Inflation is a crucial macroeconomic variable in an economy owing to its diverse and proximate influence on rapid economic growth and development. The study focused on determining the influence of public debt, trade and monetary variables on inflation. The study analyzed the effect of external debt, total debt servicing, interest rates, money supply, exchange rate, domestic credit, trade and gross domestic product on inflation in Kenya. The study used annual time series data for the period 1980 to 2010 gathered from the World Bank data bank. Data was subjected to stationarity test in which the variables were found to be nonstationary at level but stationary at first level. Augmented Dickey-Fuller (ADF) and Philips Perron were used to investigate unit root. Test for normality were done using Jacque Bera. The Johansen model of cointegration revealed the presence of a long term relationship between the variables with inflation as the dependent variable. The Vector Error Correction Model (VECM) was used to the short run relationship between the variables. Marginal change in money supply, exchange rate and external debt, had 120, 141.5 and 2.263 changes on inflation significant at 5% level of significance respectively with p values of 0.000. Also, marginal change in total debt serving, trade and gross domestic product had a 1.56, 5.01 and 109.12 change on inflation respectively at 5% level of significance respectively with p values of 0.00. The results indicated that 11.335 of the disequilibrium can be corrected by external debt .The study determined that external debt and debt servicing had a significant relationship in the short run and in the long run on inflation. However the rate of adjustment in the short run was slow for debt servicing. It was determined that money supply, trade and interest rates contribute significantly towards inflation. Trade has an inverse effect on inflation owing on bias to imports in comparison to exports. Debt payments are potentially inflationary especially for domestic borrowing. Reduction of trade deficits and interest payments will reduce debt servicing. In addition, the government should increase investment in production to increase supply of goods to meet rising demand. Reducing debt and trade deficits in expansionary periods significantly reduces pressure on prices.