The Welfare Cost of Inflation in Kenya

Abstract

The article aims to identify an appropriate money demand function that describes the Kenyan money market, then employ it to approximate the welfare cost. The empirical estimation uses quarterly data sets from 2000 (2000:01) to 2014 (2014:03). The empirical results reveals that, the appropriate money demand function that fits the Kenyan data is the semi-log model, which gives the welfare cost estimate of between 0.041 and 0.103 percent, for the inflation band. The results are consistent with literature and smaller when regression techniques are employed to derive the elasticities as opposed to using Lucas (2000) specifications. We conclude that the target inflation band maybe appropriate, however, the welfare cost estimates interest rate distortions, and any reduction may lead to welfare gains.

Keywords: Kenya’s welfare cost of inflation, ARDL Model, VECM Model