A Dynamic Model of Inflation for Kenya, 1974-1996

Abstract

This paper develops an error correction model with the aim of analysing the behaviour of prices in Kenya during 1974 -1996. In estimating the model, we first test for cointegration in the money and foreign exchange markets, using the Johansen procedure. The cointegrating vectors are then included in an autoregressive distributed-lag model, and a general-to-specific procedure is applied to obtain a parsimonious, empirically constant, error correction model. We find that in the long run inflation emanates from movements in the exchange rate, foreign prices, and terms of trade. The error correction term for the monetary sector does not enter the model, but money supply and the interest rate influence inflation in the short run. Inflation inertia is found to be an important determinant of inflation up until 1993, when about 40% of the current inflation is carried over to the next quarter. After 1993, inertia drops to about 10%. The dynamics of inflation are also influenced by food supply constraints, proxied by maize-price inflation. These findings indicate that the exchange rate is likely to be a more efficient nominal anchor than money supply, and that inflation could be made more stable by policies that secure the supply of maize during droughts.