Fiscal Policy and its effects on inflation, unemployment, and economic growth.
The Effects of Inflation on Economic Growth
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ABSTRACT
Inflation is a macroeconomic phenomenon that is associated with persistent rise in the general price
level. As the prices of commodities increase, the purchasing power of economic agents is eroded and
the effects of inflation have been more severe in developing economies like Kenya.
Inflation and economic growth are inversely related as the latter has negative consequences on the
levels of economic growth. In Kenya for instance, inflation rate has maintained an upward trend in the
recent months, hence eating deeper into household budgets and becoming the biggest threat to
economic growth this year.
This paper sets out to examine the effects of inflation on economic growth in Kenya.
The analysis will relay on secondary data obtained data from various institutions surveys notably
Kenya National Bureau of Statistics KNBS, Central Bank Kenya, World Bank and OECD National
Accounts, and ConsumersFederation of Kenya among other sources.
Ordinary Least Square Statistics Software will be used as the analytical tool to determine how inflation
affects economic growth. It is expected the outcome of this paper will assist in formulating policies
that will mitigate the negative effects of inflation.
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TABLE OF CONTENTS:
CHAPTER ONE
1.0 INTRODUCTION
1.1 Background
1.2 The statement of the problem
1.3 Objective of the study
1.4 Significance of the study
CHAPTER TWO
2.0 LITERATURE REVIEW
2.1 Introduction
2.2 Theoretical Literature review
2.4 Overview of literature
CHAPTER THREE
3.0 CONCEPTIAL FRAMEWORK
3.1 Introduction
3.2 The model
3.3 Working Hypothesis
3.4 Model specification
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CHAPTER FOUR
4.0 RESEARCH METHODS
4.1 Introduction
4.2 Data Type and source
5.0 EMPIRICAL FINDINGS
5.1 Introduction
5.2 Regression Results
5.3 Hypothesis Testing
CHAPTER FIVE
6.0 SUMMARY, CONCLUSION AND POLICY IMPLICATIONS.
6.1 Conclusion
6.2 Policy Implications/Recommendations
7.0BIBLIOGRAPHY
8.0ACRONYMS AND ABREVIATIONS
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2005 5.9
2006 6.3
2007 7
2008 1.5
2009 2.6
2010 5.6
Source: Central Bureau of Statics & Central Bank of Kenya
Chart (d): Trends of inflation and GDP in Kenya from 1991-2010
Source: Central Bureau of Statics & Central Bank of Kenya
Table (c): Estimated Contributions to Overall Inflation: FY 2009/10 & FY 2010/11
Component
Inflation (%)
FY 2009/10 FY 2010/11
Food & Non-Alcoholic Beverages 57.7 60.8
Transport 8.6 14.3
Housing, Water, Electricity, Gas & Other Fuels 11.3 13.5
Clothing & Footwear 5.1 5.5
Furnishings, Household Equipment & Routine Household 3.6 5.3
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external factors such as food shortages, weakening of Kenyan Shilling against hard currencies among
other causes.
Should inflation rates continue to sour, economic growth will slow down. This study will focus on
establishing the effects of inflation on economic growth in Kenya. The results of the study will
provide guidance to the government and other stakeholder in formulating policies and adopting policy
actions desirable in keeping inflation at levels not so harmful to economic growth.
1.3.1 General Objective
The main objective of the study is to establish the effects of inflation on economic growth in Kenya
1.3.2 Specific Objectives
To analyze and ascertain the relationship between inflation and economic growth in the period
from 1991 to 2010.
To study and explain how inflation affects the growth rate of the economy through its effects on
the purchasing power of consumers.
1.4 Significance of the study
Inflation and economic growth can be said to be inversely related as higher inflation is associated with
lower economic growth. Although inflation is not tangible, it affects the majority of the countries
populace. Its effects are felt directly by all persons r an gi n g f ro m th e r i ch an d mor e s o
among the poor. It lowers purchasing power, consumes savings, and reduces profit
and investments among other consequences; hence entire growth process is crippled.
An analysis of how inflation affects economic growth will help in the development of
po li cie s to ma in ta in in fl at ion at modera te ra tes that wi ll not hin der posi tive growth in the
economy.
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Cost-push inflation: - This is also called "supply shock inflation," is caused by a drop in
aggregate supply (potential output). This may be due to natural disasters, or increased prices of
inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can
cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on
to consumers in the form of increased prices. Another example stems from unexpectedly high
Insured Losses, either legitimate (catastrophes) or fraudulent (which might be particularly
prevalent in times of recession).
Built-in inflation: - This is induced by adaptive expectations, and is often linked to the
"price/wage spiral". It involves workers trying to keep their wages up with prices (above the
rate of inflation), and firms passing these higher labor costs on to their customers as higher
prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be
seen as hangover inflation.
Fisher (1993) found negative associations between inflation and growth in pooled cross-section, time
series regressions for a large set of countries. He argued that inflation impedes the efficient allocation
of resources by obscuring the signaling role of relative price changes, the most important guide to
efficient economic decision-making.
Jeffery Sachs and Andrew Warner (1995) observed that problems occur when inflation is greater thanpredicted, that is inflation when it is unanticipated. Such inflation has the following effects:
A redistribution of income and wealth within the economy: - When inflation rises above the
anticipated level, profits of institutions that lend money, such as banks, are eroded or even
eliminated. This is because the rate paid to depositors adjusts more quickly to market
conditions than the interest rate that banks charge borrowers. If inflation shoots upward,
interest rates immediately follow. Banks are forced to quickly raise the return to depositors,
while the rate on the overall portfolio of loans lags behind. Although banks are increasingly
making flexible-rate.
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http://en.wikipedia.org/wiki/Cost-push_inflationhttp://en.wikipedia.org/wiki/Built-in_inflationhttp://en.wikipedia.org/wiki/Adaptive_expectationshttp://en.wikipedia.org/wiki/Price/wage_spiralhttp://en.wikipedia.org/wiki/Hangover_inflationhttp://en.wikipedia.org/wiki/Cost-push_inflationhttp://en.wikipedia.org/wiki/Built-in_inflationhttp://en.wikipedia.org/wiki/Adaptive_expectationshttp://en.wikipedia.org/wiki/Price/wage_spiralhttp://en.wikipedia.org/wiki/Hangover_inflation -
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Reduction of real wage for workers on fixed contracts: - If a labor union makes a long-term
agreement for salary increases based on the projected inflation rate, then the real wage may
actually decline if the inflation rate shifts up.Similarly, many pensioners are on fixed pensions
and thus inflation reduces the real value of their income every year.
Inflation distorts the price mechanism by making it difficult to distinguish changes in
relative prices from changes in the general price level: - Changes in relative prices may be
offset by the substitution of lower price inputs used in production. If almost all prices are rising
rapidly, there is little incentive to search for cheaper substitutes that could help keep production
costs low.
Inflation creates uncertainty and reduces investment:-If businessmen are unsure about the
future level of prices, and thus of real interest rates, they will be less willing to take risks and
invest, especially in long-term projects. As investment is reduced, so is the long-run growth
potential of the economy.
There may be a redistribution of resources and production into areas less affected by
high inflation rates: - Inflationary hedges are used to try to keep up with the effects of
inflation, possibly to the detriment of the economy. The classic inflationary hedge is gold (and
other precious metals). Gold is desirable in times of high inflation because the paper currency
issued by the government rapidly loses its value (purchasing power), while gold prices tend to
keep pace with inflation. The reason is that inflation increases the opportunity cost of holding
paper currency (which loses its value) and gold is the closest available substitute. As the
demand for gold increases, the price of gold rises (along with inflation). As savers shift their
assets into gold, they reduce their holdings of stocks and bonds. This reduces the supply of
funds available for businesses to borrow, raising the cost of investment ( r, the interest rate).
The result is less business investment and a reduction in the economic growth rate.
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Inflationary uncertainty pushes up real interest rates, as lenders demand a bigger risk
premium on their money: - Longer-term interest rates are especially punished as a high
inflation premium is added to account for inflationary uncertainty. As a result, the cost of
borrowing by businesses and consumers increases substantially, reducing the rate of real
economic growth.
Overall redistribution of productive and financial resources may lead to a loss in
efficiency: - As economic efficiency falls, so does the production of goods and services.
Reduction in exports and increase in imports: - Rise in relative inflation leads to a fall in the
world share of a countrys exports and a rise in import penetration. Ultimately, this will lead to
a fall in the rate of economic growth and the level of employment.
Wage-price spiral effects: Rise in prices can lead to higher wage demands as workers try to
maintain their real standard of living. Higher wages over and above any gains in labour
productivity causes an increase in unit labour costs. To maintain their profit margins they
increase prices. The process could start all over again and inflation may get out of control.
Rise in shoe leather costs: - When prices are unstable there will be an increase in search times
to discover more about prices. Inflation increases the opportunity cost of holding money, so
people make more visits to their banks and building societies (wearing out their shoe leather!).
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Menu costs: - Extra costs to firms of changing price information. This can be important for
companies who rely on bulky catalogues to send price information to customers. (Note there
are also significant menu costs associated with any future transition to the European Single
Currency)
Barro (1995) examined the five-year average data of 100 countries over the period of 1960-90 by using
the Instrumental Variable (IV) estimation method. He obtained a robust estimation result showing that
an increase in average inflation by 10 percentage points per year would slow the growth rate of the real
per capita GDP by 0.2-0.3 percentage points per year. He argued that although the adverse influence of
inflation on growth appeared small, the long-term effects on standards of living were actually
substantial.
Economy Watch (2010) identified inflation as a condition, when cost of services coupled with goods
rise and the entire economy seems to go haywire. It noted that has never been good to the economy.
However, whenever there is expected inflation, governments around the world take appropriate steps
to minimize the ill effects of inflation to a certain extent. Inflation and economic growth are parallel
lines and can never meet. Inflation reduces the value of money and makes it difficult for the common
people. Inflation and economic growth are incompatible because the former affects all sectors.
Ndungu (1994) and Adam et al (1996) obtained results which indicated that money supply drivesinflation. However, according to Ndungu, there is only a short-run relationship between these
variables; deviations from equilibrium in the money market do not enter the model and thus money
does not determine the price level in the long run.
Business Daily (2011) in Nairobi quoted Fitch, an international credit rating agency, saying Kenya's
credit rating could drop as her economic fundamentals and growth were threatened by rising inflation
and the depreciating Shilling and rising political anxiety ahead of next year's General Election.
There are various methods of measuring inflation and they include consumer price index (CPI),
producer price index (PPI) and wholesale price index. However, consumer price index (CPI) is the
most widely used in Kenya. It is calculated as follows: assuming the inflation rate for 2010 represents
the rate of price increases of the weighted basket of goods (the CPI) since 2009. The calculation is:
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Inflation rate (2010) =CPI (2010) - CPI (2009)
x 100
CPI (2009)
2.2 OVERVIEW OF THE LITERATURE
From the literature, inflation is the persistent rise in the general price level. Three major types inflation
exists. These are demand-pull inflation,cost-push inflation andbuilt-in inflation.
High Inflation affects economic growth cause many economic distortions, including slower growth
and higher unemployment. However, low inflation rates yield benefits such as
Making possible the fastest long-term growth.
Eliminating the distorting consequences of unpredicted inflation.
Reducing the uncertainty and inefficiency associated with inflation.
Although inflation affects economic growth, many economists have not established proportion by
which inflation slows or accelerates growth. But analysis by Barro (1995) indicates that an increase in
average inflation by 10 percentage points per year would slow the growth rate of the real per capita
GDP by 0.2-0.3 percentage points per year. According to him, adverse influence of inflation on growth
appears small, but the long-term effects on standards of living are actually substantial.
In Kenya There are has scarcity of studies explaining the extent to which inflation affects economic
growth. Thus this study will help in establishing whether there is any relationship inflation and
economic growth.
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http://en.wikipedia.org/wiki/Demand-pull_inflationhttp://en.wikipedia.org/wiki/Demand-pull_inflationhttp://en.wikipedia.org/wiki/Cost-push_inflationhttp://en.wikipedia.org/wiki/Built-in_inflationhttp://en.wikipedia.org/wiki/Built-in_inflationhttp://en.wikipedia.org/wiki/Demand-pull_inflationhttp://en.wikipedia.org/wiki/Cost-push_inflationhttp://en.wikipedia.org/wiki/Built-in_inflation -
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3.0 CHAPTER THREE
3.1 CONCEPTUAL FRAMEWORK
This analysis seeks to establish the relationship between inflation and the rate of economic growth in
Kenya.
3.2 THE MODEL
In this analysis, the model has two variables, that is
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i. Inflation (independent variable); and
ii. Economic growth rate (dependent variable)
The model is expressed as follows:
Y=f (I)
Where Y is the level of economic growth rate (GDP)
I is the level of inflation
Expressing the model equation form: Y = + I +
Where: is the intercept
is the slope
is the error/residual term
3.3 STATEMENT OF HYPOTHESIS
Null hypothesis: High rate of inflation has lead to a slow economic growth rate in Kenya.
Null hypothesis: High rates of economic growth in Kenya are not due to low levels of inflation.
3.4 SPECIFICATION OF THE MODEL
The study seeks to set out a model to estimate the linear function of the effects of inflation on the
economic growth rate in Kenya for a period of 20 years stretching from 1991-2010.
4.0 CHAPTER FOUR
4.1 RESEARCH METHODS
4.2 INTRODUCTION
In the design of the analysis, a regression model is designed from secondary data collected for period
of 20 years from1991 to 2010. It was from different Economic Surveys, Statistical Abstracts, IMF and
World Bank Publications and was intended to explain the relationship between inflation and economic
growth in Kenya.
4.3 DATA TYPE AND SOURCE
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Data collected for the research was from secondary sources. It was obtained mainly Economic
Surveys, Statistical Abstracts, IMF and World Bank Publications among other sources. It was then
tested by regression using the Ordinary Least Square (OLS) statistics tool.
5.0 CHAPTER FIVE
5.1 FINDINGS
5.2 INTRODUCTION
This analysis set out to investigate the effect of inflation on economic growth in
Kenya. The analysis is based on a sample data for 20 years starting in 1991
through to 2010.
The relationship between the variables was then tested by using computer
statistics software, that is, Ordinary Least Square Method.The results of the
analysis were as tabulated below.
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5.3 RESULTS OF INFLATION RATE, GDP GROWTH RATE BETWEEN 1991 AND 2010IN KENYA
YEAR Y I y i y2 i2 yi
1991 4.3 19.6 1.07 7.34 1.14 53.88 7.85
1992 2.3 27.3 -0.93 15.04 0.86 226.20 -13.991993 0.2 46 -3.03 33.74 9.18 1138.39 -102.23
1994 3 28.8 -0.23 16.54 0.05 273.57 -3.80
1995 4.8 1.6 1.57 -10.66 2.46 113.64 -16.74
1996 4.6 9 1.37 -3.26 1.88 10.63 -4.47
1997 3.4 11.2 0.17 -1.06 0.03 1.12 -0.18
1998 1.8 6.6 -1.43 -5.66 2.04 32.04 8.09
1999 1.4 5.8 -1.83 -6.46 3.35 41.73 11.82
2000 0.2 10 -3.03 -2.26 9.18 5.11 6.85
2001 1.2 5.8 -2.03 -6.46 4.12 41.73 13.112002 0.5 2 -2.73 -10.26 7.45 105.27 28.01
2003 2.9 9.8 -0.33 -2.46 0.11 6.05 0.81
2004 5.1 11.8 1.87 -0.46 3.50 0.21 -0.86
2005 5.9 9.9 2.67 -2.36 7.13 5.57 -6.30
2006 6.3 6 3.07 -6.26 9.42 39.19 -19.22
2007 7 4.3 3.77 -7.96 14.21 63.36 -30.01
2008 1.5 15.1 -1.73 2.84 2.99 8.07 -4.91
2009 2.6 10.5 -0.63 -1.76 0.40 3.10 1.11
2010 5.6 4.1 2.37 -8.16 5.62 66.59 -19.34Total
Sum 64.6 245.2 85.14 2235.43 -144.39
Recall the equation: Y = + I +
Economic growth mean rate, (My) = Y/n=64.6/20=3.23
n=Number of years=20
u=U- My
Inflation mean rate, (Mi) =I/n = 245.2/20=12.26
n=Number of years=20
i=I- Mi
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=1-(1-0.11)*19/18
=0.06
The adjusted R2 is 0.06. This implies that an annual average increase in inflation by 12.26% accounts
for 6% of the economic growth distortion. Hence other factors account for 94% of the growthdistortion. This finding is closely related to the finding of Barro (1995) who asserted that an increase
in average inflation by 10 percentage points per year would slow the growth rate of the real per capita
GDP by 0.2-0.3 percentage points per year.
6.0 CHAPTER SIX
6.1 CONCLUSION
Although our findings shows inflation as affecting economic growth by a small percentage (6%) it is
not doubt the effect of inflation has hit hard on the cost of living of many Kenyans. This is because the
current state of inflation is driven by factors that touch on the lives of very Kenyan. These factors
include high of food stuff and fuel and slump in the value of Kenyan shilling against major world
currencies.
Generally, inflationary pressures in Kenyan have been combated through monetary and fiscal policy
measures depending on the cause of inflation. In the case of demand-pull inflation, monetary policy
instruments are employed. Such instruments may include:
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Restriction of direct lending to the government in Kenya.
Reduction of cash or liquidity ratio requirements on the commercial banks and financial
institutions; hence reducing their ability to create credit.
Raising the cost of borrowing through the sale of treasury bills in open market operations.
Fiscal policy instruments on the other hand may include measures like raising taxes in order to cut
consumers income and hence their level of spending; reduction of government expenditure through
lowering government borrowing to finance budget deficits.
6.2 POLICY RECOMMENDATION
In the recent times, inflation pressure has been skyrocketing prompting every monetary authority to
put it under check and quickly before there is erosion on the purchasing power of money. The Central
bank attributes the current inflation in Kenya to supply side problems. It thus noteworthy that curbing
in inflation in Kenya will require a mixture of both monetary and fiscal measures that include:
1. The Government should take direct measures to reduce the very large inflationary pressures
resulting from supply shocks associated with sharp increases in food and energy prices as
opposed to holding back growth by raising interest rates and trying to contain inflation at five
percent or less. This may be achieved by:
Maintaining a buffer stock of strategic grain surpluses that is released when needed to dampen the
effects of food-supply shocks.
On oil price shocks, government may temporarily raise subsidies for public transportation and
electricity rather than allow prices of these necessities to build inertial upward momentum.
Alternatively, other sources of energy, including geothermal, solar and wind should be developed
to reduce heavy reliance on imported fuel.
2. The government should scrap price control that have been introduced recently especially on fuel
prices. Such price setting has aggravated rate of inflation especially in rural areas as firms are
charging higher prices as they move from Nairobi to rural towns like Mandera and Kisumu.
Furthermore, the ERC formula uses international crude oil prices. It is highly likely therefore if
there is an increase in the international crude oil prices, oil marketers, seeing the trend and aiming
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at profit maximization could hoard fuel in anticipation of fuel price increase when new prices are
calculated, thereby leading to fuel shortage.
3. The government should minimize rapid depreciation of the Kenyan shilling that is said to generate
inflationary pressures. This can been achieved, over the longer term, by building domestic
industries capable of producing substitutes for a rising share of Kenyas imported products.
4. On Monetary Policy Operation, the CBK should resist from focusing on maintaining control over
the growth rate of the money supply. This is because the expansion of the supply of money and
credit is strongly influenced by the demand for credit by both domestic and foreign businesses.
Instead, emphasis should be on interest-rate which should be maintained as low as possible in
order to expand affordable credit throughout the economy and minimize the servicing of the
domestic public debt. Increasing interest rates as it is happening in Kenya will increase default rateand provision of bad debts, deter potential investors from borrowing which will reduce investment
and saving. The end result will be reduction in deposits as there will no surplus for saving and
overall economic growth will decline. Besides, setting the short-term interest rate can also be used
to promote a stable and competitive exchange rate.
5. As a short term measure, the government should cushion its rural poor population and low income
earners by waving taxes on essential such as kerosene, maize and wheat in a bid to ease the burden
of a rising cost of living.
6. The government should cautiously by revising the income people with fixed incomes especially the
pensioners. Many pensioners are on fixed pensions, so inflation reduces the real value of their
income every year. The state pension should normally be up-rated each year in line with average
inflation so that the real value of the pension is not reduced.
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