An Empirical Analysis of the Effects of Fiscal Deficit on Inflation Kenya

Abstract

A key objective of macroeconomic policies is to foster high economic growth while maintaining low and stable rate of inflation. The relationship between public sector deficits and inflation is one of the important but controversial issues in both academic and empirical literature. Maintaining a stable inflation plays an important role in determining the growth rate of output. The main objective of this paper is to investigate the effects of fiscal deficit on inflation in Kenya based on quarterly data for the period 1996q1-2017q2. The results indicate no evidence of causal effect on either direction between inflation and fiscal deficit in Kenya. This is mainly attributed to how fiscal deficit is financed in Kenya. Deficit is financed through domestic and foreign debts due to restrictions of central bank’s financing of deficits. Existence of a well-developed financial market for government securities and good international rating has facilitated smooth debt uptake. It is however observed that the continuous increase in both domestic and foreign debts above the growth rate of the economy may eventually reach an unsustainable levels and the government would have no alternative but to resort to seigniorage to meet its debt obligations. Growth of the economy, exchange rate depreciation, monetary policy stance and money supply are found to be the key determinants of inflation in Kenya during the period of study.

Keywords: Fiscal Policy, Monetary policy, Fiscal Deficit, Inflation, Money Supply