the effects of inflation on economic growth

7/31/2019 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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the effects of inflation on economic growth

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