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 Consumers Federation 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.

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

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 7.0 BIBLIOGRAPHY 8.0 ACRONYMS AND ABREVIATIONS

1.0 CHAPTER ONE 1.1 BACKGROUND Inflation is a continuous increase in the price level, sustained over a period of time. Inflation may be caused by a continuous increase in the supply of money, a continuous decrease in the demand for money, or a combination of the two. Government might very well and often do increase the money supply continuously. If the demand for money were fixed, then the price level would grow at the same rate as money supply. Rising real incomes usually cause the demand for money to rise over time. This tempers the inflationary effect of money supply growth, and so the price level typically grows more slowly than the money supply. Even so, a higher rate of money supply growth is expected to cause a higher rate of inflation. The effects of inflation can be disastrous and more so in developing countries. This has made prospects of continued growth for countries like Kenya to be unpredictable as inflation has been on the increase going as high as 17.3% in September of 2011. This high inflation has been attributed to a steep rise in the cost of food, transport, restaurants and hotels, weakening Kenya shilling and failure by monetary policy action to curb inflation. As a result of high inflation, Economists reckon that should the current trend continue, the economy will lose the gains made in sectors such as infrastructure and close the year below the target 5.7 per cent.Realizing the target growth will be a challenge because high inflation limits consumer spending and inevitably hurts growth, said PineBridge Investments senior manager Edward Gitahi. In attempt to investigate the effects of inflation on economic growth, the following tables and charts have been used to show inflation and economic growth in Kenya from the year 1991-2010 and the biggest inflation components in the past two years. Table (a): Inflation Trends in Kenya (1991-2010)

YEAR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

INFLATION RATE (%) 19.6 27.3 46.0 28.8 1.6 9.0 11.2 6.6 5.8 10 5.8 2.0 9.8 11.8 9.9 6.0 4.3 15.1 10.5 4.1

Source: Central Bureau of Statics & Central Bank of Kenya

Table (b): GDP Trends in Kenya (1991-2010) YEAR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 GDP Rate (%) 4.3 2.3 0.2 3 4.8 4.6 3.4 1.8 1.4 0.2 1.2 0.5 2.9 5.1

2005 2006 2007 2008 2009 2010

5.9 6.3 7 1.5 2.6 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 Inflation (%) FY 2009/10 57.7 8.6 11.3 5.1 3.6

Component Food & Non-Alcoholic Beverages Transport Housing, Water, Electricity, Gas & Other Fuels Clothing & Footwear Furnishings, Household Equipment & Routine Household

FY 2010/11 60.8 14.3 13.5 5.5 5.3

Restaurants & Hotels 3.7 Health 3.5 Alcoholic Beverages, Tobacco & Narcotics 3.3 Miscellaneous Goods & Services 3.2 Education 0.1 Recreation & Culture 0.4 Communication -0.6 Source: Kenya National Bureau of Statistics & Central Bank of Kenya

5.2 3 2.8 2.4 1.5 1.3 -15.6

Source: Kenya National Bureau of Statistics & Central Bank of Kenya

1.2 STATEMENT OF THE PROBLEM Kenyan economy has suffered severely owing to negative effects of high inflation rates. This has forced Kenyans to cut down on the amount spent per shopping experience owing to the high cost of goods. Firms have not been spared either and have resorted to downgrading their growth expectations and issuance of early negative profit warnings. Although the government has attempted to cushion its citizens against rising commodity prices, this has had very little effect in lowering the cost of living and doing business in Kenya as the ongoing inflation is a conglomeration numerous internal and

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 a n g i n g f r o m t h e r i c h a n d m o r e s o a m o n g t h e p o o r . 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 policies to maintain inflation at moderate rates that will not hinder positive growth in the economy.

2.0 CHAPTER TWO

2.1 LITERATURE REVIEW The investigations into the existence and nature of the link between inflation and growth have experienced a long history and different economists have expressed this relationship as detailed here under. Mises L. V (2010) defines inflation as increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to fail because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation. Gordon R. (1991) identified three major types of inflation: these were

Demand-pull inflation: - This is caused by increases in aggregate demand due to increased

private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion.

 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 than predicted, 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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 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 drives inflation. 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 and built-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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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 Economic growth rate (dependent variable)

ii.

The model is expressed as follows: Y=f (I) Where Y I is the level of economic growth rate (GDP) is the level of inflation + I +

Expressing the model equation form: Y = Where: is the intercept is the slope is the error/residual term

3.3 STATEMENT OF HYPOTHESIS Null hypothesis: Null hypothesis: High rate of inflation has lead to a slow economic growth rate in Kenya. 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 2010
IN KENYA YEAR 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total Sum Y 4.3 2.3 0.2 3 4.8 4.6 3.4 1.8 1.4 0.2 1.2 0.5 2.9 5.1 5.9 6.3 7 1.5 2.6 5.6 64.6 I 19.6 27.3 46 28.8 1.6 9 11.2 6.6 5.8 10 5.8 2 9.8 11.8 9.9 6 4.3 15.1 10.5 4.1 245.2 + I + y 1.07 -0.93 -3.03 -0.23 1.57 1.37 0.17 -1.43 -1.83 -3.03 -2.03 -2.73 -0.33 1.87 2.67 3.07 3.77 -1.73 -0.63 2.37 i 7.34 15.04 33.74 16.54 -10.66 -3.26 -1.06 -5.66 -6.46 -2.26 -6.46 -10.26 -2.46 -0.46 -2.36 -6.26 -7.96 2.84 -1.76 -8.16 y2 i2 yi 1.14 53.88 7.85 0.86 226.20 -13.99 9.18 1138.39 -102.23 0.05 273.57 -3.80 2.46 113.64 -16.74 1.88 10.63 -4.47 0.03 1.12 -0.18 2.04 32.04 8.09 3.35 41.73 11.82 9.18 5.11 6.85 4.12 41.73 13.11 7.45 105.27 28.01 0.11 6.05 0.81 3.50 0.21 -0.86 7.13 5.57 -6.30 9.42 39.19 -19.22 14.21 63.36 -30.01 2.99 8.07 -4.91 0.40 3.10 1.11 5.62 66.59 -19.34 85.14 2235.43 -144.39

Recall the equation: Y =

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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Y =

+ I +

, =parameters=k = Error term =Sum of yi /Sum of i2 = yi/i2 = -144.39/2235.43 = -0.06 The OLS assumption in this analysis is that the random term has a zero mean and its variance is constant for all values. Thus =0 The regression is estimated as: , =parameters=k = y - I

= 3.23 - (-0.06*12.26) =3.97 Regression line, Y = 3.97-0.06I We get the coefficient of determination R2 so that to test how much of the variations in economic growth (Y) is explained by variations in inflation. R2
= =

(yi) 2//y2 i2 (-144.39)2 (85.14)(2235.43) 20,848.47 190,324.51 0.11

R2

R2

5.4 HYPOTHESIS TESTING Adjusted R2 is then used to take into account the corresponding degrees of freedom Adjusted R2 =1-(1 -R2) (n-1)/ (n-k) Where k= number of parameters

= 1-(1-0.11) (20-1)/ (20-2)

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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 growth distortion. 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 rate and 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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