EFFECTS ON INFLATION ON ECONOMIC GROWTH IN KENYA:

AN EMPRICAL ANALYSIS

Abdikadir Mohammed
X51/35571/2019

A RESEARCH PROPOSAL SUBMITTED TO THE SCHOOL OF ECONOMICS IN

PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE AWARD OF THE
DEGREE OF MASTERS OF ARTS IN ECONOMIC POLICY MANAGEMENT OF
THE UNIVERSITY OF NAIROBI
©2024

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 CHAPTER ONE: INTRODUCTION
1.1 Background of the Study
As economies around the world strive to recover from covid-19 pandemic, rising inflation
and inflation uncertainty has become a global phenomenon raising serious concerns. Global
economic activity is undergoing a widespread and more pronounced deceleration,
accompanied by inflation levels that have surpassed those observed over the last several
decades (IMF, 2022). The conflict between Russia and Ukraine has further, exacerbated
inflationary pressures, resulting in significant rises in energy and food prices due to their
prominent roles as suppliers to numerous importing economies, particularly European nations
(CREEL & GEEROLF, 2023). This has and continue to yield serious economic repercussions
in many economies, both developed and emerging.

Globally, elevated inflation rates are often correlated with diminished economic growth and
the onset of financial crises (Ha et al., 2019). The escalation of price levels is linked to
diminished investor confidence, reduced incentives for saving, and the deterioration of
financial and public sector balance sheets. This assertion is supported by Klemm et al.,
(2023) who assert that the distortion of the price structure created by inflation is also likely to
indirectly discourage saving and encourage consumption. Moreover, as Gern et al. (2023)
posit, the adverse effects of high inflation tend to disproportionately impact low-income
individuals, as they rely more heavily on wage earnings, have limited access to interest-
bearing accounts, and possess minimal holdings of financial or tangible assets beyond cash.
In most nonindustrial countries, investment often relies heavily on imported components.
Thus, inflation-driven depreciation of the exchange rate, coupled with protective import
substitution measures implemented by authorities, commonly result in significant price hikes
for investment goods (Shitundu & Luvanda, 2000).

In Africa, high inflationary pressures have over the decades adversely impacted the continent.
In November 2022, the Eastern and Southern Africa region experienced a peak in inflation at
19.4% year-on-year, reflecting significant economic challenges across various economies in
these regions (Plé, 2023). Although there has been a gradual decline since then, with regional
inflation dropping to 15.5% in July 2023 (Plé, 2023), variations exist among nations.
Furthermore, the Sub-Saharan African emerging economies confront significant
macroeconomic challenges stemming from elevated inflation, compounded by the possibility
of currency depreciation triggered by stricter monetary policies in developed nations (Laurent
Kemoe et al., 2023).

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As a result, central banks and monetary authorities in these economies have been compelled
to regulate inflation by adjusting short-term interest rates through monetary policy (Mersch,
2017), aiming to influence economic activity and mitigate inflationary pressures. Ueda
(2023) finds that major central banks have from time to time, swiftly and significantly
tightened their monetary policies in response to high inflationary pressures in order to curb
any adverse effects in the economy. South Africa, for instance, saw its inflation rate decrease
to 4.7% in July 2022, aligning with the Central Bank's target range of 3-6% (IMF, 2023). The
South African Reserve Bank (SARB) maintained its key rate at 8.25%, marking a pause in
the series of rate hikes implemented since November 2021. Despite this, inflation forecasts
remain uncertain, with potential risks such as power shortages and fuel price increases.

Similarly, Kenya has experienced fluctuations in inflation but has largely stayed within the
Central Bank's target range of 2.5-7.5% (CBK, 2023). The Monetary Policy Committee
raised the key rate to 10.5% in June 2022, aiming to mitigate inflationary pressures. Despite
recent policy changes, including VAT adjustments in 2022, the Central Bank of Kenya
expected inflation to stabilize in the coming months, leading to a pause in monetary
tightening measures. Maintaining low and stable inflation rates has been associated with
improved economic growth and development outcomes, enhanced financial stability, and
poverty alleviation efforts.

1.1.1 Trends and overview of inflation in Kenya

Kenya's inflation history reflects periods of both high and low inflation over the last four
decades as shown by figure 1.1.

Figure 1.1: Kenya’s Annual Percentage (%) Change in Consumer Price Index between 1980 – 2022.

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 50.00
45.98
45.00
40.00
35.00
30.00
25.00
20.00
15.00
10.00
5.00
1.55
0.00
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
Source: Author’s Visualization from the World Bank Data.
Figure 1.1 reflects Kenya’s annual percentage change in inflation as measured by the
consumer price index (CPI) between the years 1980 – 2022. The y-axis shows the percentage
change in annual CPI, while the x-axis represents the time interval in years.

Over the past four decades, Kenya has witnessed fluctuating inflation rates with a marginally
declining trend. In 1993, the country experienced galloping inflation, reaching its highest
level of 45.98%. Conversely, two years later, inflation dropped to 1.55%, marking its lowest
point during this period. Over the past decade, Kenya's inflation rate has averaged 6.54%,
with food and fuel prices consistently serving as the primary drivers of overall inflation
during the period analyzed.

To stabilize inflation expectations, the Monetary Policy Committee (MPC) gradually

increases the policy rate (Central Bank Rate (CBR)) from time to time to address pressures
on the exchange rate and mitigate secondary effects, particularly from global price
movements (Government of Kenya, 2024). For instance, the MPC hiked the CBR from
7.50% in May 2022 to 10.50% in June 2023, and further to 12.50% in December 2023. This
tightening of monetary policy – reflecting periods of significant fluctuations or policy
interventions - was implemented to ensure that inflation expectations remained stable, while
steering inflation towards the midpoint target of 5.0% in line with the government target
range of 5±2.5 percent for the period.

1.1.2 Trends and overview of economic growth in Kenya

Kenya's GDP growth rate history, just like inflation, reflects periods of both high and low
growths and declines over the last four decades as shown by figure 1.2.
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Figure 1.1: Kenya’s Annual GDP Growth Rate (%) between 1980 and 2022.
10.00

8.00 8.06

6.00

4.00

2.00

0.00
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
-2.00 -0.80

Source: Author’s Visualization from the World Bank Data.

Figure 1.2 shows Kenya’s annual GDP growth rate between the years 1980 and 2022. The y-
axis shows the percentage change in annual GDP growth rate, while the x-axis represents the
time interval in years.

Over the period under review, Kenya recorded the highest GDP growth rate of 8.06% in
2010, and registered a recession of – 0.80% in 1992. The country’s economy exhibited
remarkable resilience in response to the COVID-19 shock, achieving a growth rate of 7.5% in
2021, a recovery that was primarily driven by strong performance in the service and industry
sectors. This marked a significant improvement from the contraction of 0.3% experienced in
2020 (The National Treasury and Planning, 2022). According to the fourth National Treasury
Quarterly Economic Review in the 2021/22 financial year, the country’s economy exhibited
robustness and resilience during the first quarter of 2022, expanding by a notable 6.8 percent
compared to the 2.7 percent growth observed in the same period in 2021. With the exception
of agriculture, which experienced a contraction of 0.7 percent due to adverse weather
conditions affecting crop production, all sectors recorded positive growth rates (The National
Treasury and Planning, 2022). However, the government emphasizes the importance of
responsibly managing public resources to promote inclusive economic growth and
development.

However, Kenya’s economy continues to grapple with various challenges that pose threats to
its growth, These challenges include heightened fiscal and external vulnerabilities, marked by
high public debt levels, increased cost of living, exchange rate fluctuations, global economic
uncertainties, and stringent global financial conditions (World Bank Group, 2023). To ensure

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equitable distribution and long-term sustainability of economic growth, Kenya must develop
a strategy to reignite inclusive growth and enhance private sector productivity. This is
essential for maintaining high rates of economic growth aligned with the objectives of the
Bottom-Up Economic Transformation (BETA) agenda.

1.1.3 Inflation and Economic Growth Relationship in Kenya

The theoretical relationship between inflation and economic growth is a subject of ongoing
debate. Various economists argue that rising prices contribute to diminished growth, positing
that elevated prices result in economic losses. However, this perspective contrasts with the
Mundell-Tobin Effect, which contends that heightened inflation prompts individuals to
reduce cash holdings and increase investment, consequently lowering loan rates and fostering
economic growth (Obiero, 2022).

Economists like Fry (1988) posit a negative correlation, arguing that inflation reduces
purchasing power, discourages investment, and ultimately hinders economic activity (Ali &
Asfaw, 2023). Fischer (1993) introduces the concept of a threshold effect, suggesting that
moderate inflation might not be detrimental, but excessively high inflation can significantly
hinder growth (Mallik et al., 2001). In another study, Fischer (1993) and Barro (1996)
observed a minimal adverse effect of inflation on economic growth. Despite the limited
evidence, Fischer (1993) emphasized the detrimental impact of inflation on long-term
growth. Similarly, Barro (1996) advocated for price stability, citing its positive influence on
economic growth.

Saungweme and Odhiambo (2021) analyzed the correlation between inflation and economic
growth in Kenya through both analytical and empirical approaches. Their study discovered
structural breaks in inflation and economic growth in Kenya in 1995 and 1991, coinciding
with the country's economic, financial, public sector, and institutional reforms during those
periods. Additionally, the research revealed a statistically significant negative impact of
inflation on long-term economic growth. Furthermore, the multivariate Granger-causality
analysis indicated a distinct short-term unidirectional causality from economic growth to
inflation in Kenya.

In a different study, Osborn et al. (2016) explored the factors influencing inflation in the
Kenyan economy. They conducted an empirical analysis to assess the relationship between
inflation and its determinants. The results indicated that price fluctuations and lagged
inflation rates positively influence the inflation rate, while real GDP growth has a negative

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effect on inflation. Based on these findings, the study concluded that real GDP growth, price
fluctuations (such as changes in oil prices), and lagged inflation rates are the primary
determinants of inflation in Kenya.

The studies reviewed above reveal a lack of consensus regarding the precise effect of
inflation in developing economies such as Kenya, and the theoretical debate is still ongoing,
whether GDP growth precipitates inflation or if inflation hinders GDP growth. Existing
studies often focus on a broader range of developing countries, potentially overlooking the
unique characteristics of the Kenyan economy. However, empirical evidence on the specific
effect of inflation on economic growth in developing economies like Kenya remains
inconclusive. Therefore, there is a pressing need for empirical research, specifically tailored
to the Kenyan context to shed light on this crucial relationship.

1.2 Statement of the problem

Kenya has experienced periods of both high and low inflation in recent decades. The
country's Central Bank strives to maintain inflation within a target range to promote
economic stability. However, factors like global commodity price fluctuations, exchange rate
movements, and government spending can influence inflation levels. Amidst heightened
geopolitical tensions and supply chain disruptions, exacerbated by weakening demand in key
economies like China and the Eurozone, global interest rates are on the rise due to
inflationary pressures. This trend restricts access to credit and increases debt servicing costs,
further compounded by substantial losses from extreme weather events. Consequently, global
growth is projected to decelerate to 3.0 percent in 2023 and 2.9 percent in 2024, falling below
the historical average of 3.8 percent recorded between 2000 and 2019 (Government of
Kenya, 2024).

Inflation affects all aspects of the Kenyan economy, from consumer spending, business
investment and employment rates to government programs, tax policies, and interest rates.
Understanding inflation is crucial to investing because inflation can reduce the value of
investment returns. Understanding inflation is crucial to investing because it can reduce the
value of investment returns. With inflation rising recently after several years of relative calm
to its highest level in four decades, investors may benefit from knowing the factors driving
inflation, the impact on their portfolios, and steps to consider as the investment landscape
shifts.

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Despite the Central Bank of Kenya's efforts to maintain inflation within a targeted range,
economic growth in Kenya has fluctuated. A clear understanding of how inflation affects
economic growth in the Kenyan context is crucial for policymakers to formulate effective
policy strategies. This research aims to bridge this knowledge gap by conducting an empirical
analysis on the effect of inflation on economic growth in Kenya.

Much of the research about inflation-GDP growth relationship has been conducted among
countries. However, the conclusion on the effect of inflation on GDP growth is still debated.
Empirical research suggests that the relationship between inflation and GDP growth is
different from one country to another. Therefore, conducting research on inflation-GDP
growth relationship for the better policy responses is essential. This proposed study aims to
fill this gap by conducting a rigorous empirical investigation into the effects of inflation on
economic growth in Kenya. By analyzing comprehensive and locally relevant data, this
research seeks to provide actionable insights for policymakers and stakeholders to formulate
effective economic policies and strategies for sustainable development.

1.3 Objectives of the Study

1.3.1 General Objective

The general objective of this study is to empirically investigate the effect of inflation on
economic growth in Kenya.

1.3.2 Specific Objectives

1. To estimate the threshold level of inflation on economic growth in Kenya.
2. To investigate the granger causality relationship between inflation and economic
growth in Kenya.
3. To provide actionable recommendations to policymakers based on the empirical
findings of the study.
1.4 Research Questions

The study seeks to answer the following research questions.

1. What is the threshold level of inflation beyond which it significantly impacts

economic growth in Kenya?
2. Is there a causal relationship between inflation and economic growth in Kenya?
3. What specific recommendations can policymakers derive from the empirical findings
of the study?

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1.5 Significance of the study

The findings of this study will be significant for various stakeholders:

Policymakers: This research will provide valuable insights for the Central Bank of Kenya
and other policymakers in formulating inflation management strategies that promote
sustainable economic growth. Understanding the threshold effect can help them prioritize
inflation control measures without stifling economic activity.

Businesses and Investors: By understanding the impact of inflation on economic growth,

businesses can make informed investment decisions and adjust their strategies accordingly.

Academic Community: This research contributes to the ongoing debate on the relationship
between inflation and economic growth in developing economies. It will offer valuable
insights specific to the Kenyan context, potentially enriching existing knowledge.

1.6 Scope and limitation of the study

This study will focus on the effects of inflation on economic growth in Kenya. Focusing on
Kenya offers several justifications. Firstly, Kenya's economy has experienced fluctuations in
both inflation and economic growth over the specified period, making it an ideal case study
for investigating their relationship. Additionally, Kenya's economic structure and policy
environment present unique factors that may influence this relationship, such as changes in
monetary policy, fiscal measures, and external shocks.

The study will investigate the effect of inflation on economic growth in Kenya from 1980 to
2022. This time frame allows for an extensive analysis of the relationship between inflation
and economic growth over four decades, providing insights into long-term effects, trends and
patterns.

The study will utilize time-series data on inflation rates and GDP growth obtained from
reliable sources like the CBK and Kenya National Bureau of Statistics (KNBS). This will
ensure the reliability and accuracy of the analysis. These data sources provide comprehensive
and consistent information, allowing for robust econometric analysis.

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The study will employ econometric techniques such as Granger causality tests or Vector
Autoregression (VAR) models to analyze the data. These methods are widely recognized and
accepted in economic research for examining causal relationships and dynamics between
variables over time. By employing rigorous statistical techniques, the study aims to provide
robust empirical evidence on the effects of inflation on economic growth in Kenya.

The study has one limitation. The analysis may not capture the full effect of all factors
influencing economic growth, such as global shocks or political instability. These external
factors can exert pressure on key economic indicators such as GDP growth, investment
levels, and inflation rates. However, due to the focus on inflation as the primary variable of
interest, the study may not comprehensively account for the complex interplay between
global shocks and economic growth.

1.7 Delimitation of the Study

This study will not delve into the causes of inflation in Kenya. Investigating the causes of
inflation would require an extensive analysis of each of these factors, potentially exceeding
the scope of the study and diverting attention from the primary objective of examining the
relationship between inflation and economic growth.

CHAPTER TWO: LITERATURE REVIEW

2.1 Introduction

This chapter examines the existing theories and research on the effect of inflation on
economic growth from different studies. The theoretical framework draws on Philips Curve
Theory by A.W. Phillips and the Endogenous Growth Theory by Paul Roma. The empirical
review focuses on past studies that investigate the relationship between inflation and
economic growth across different countries. Based on this review, the chapter presents a
conceptual framework that visually depicts the relationship between the independent and
dependent variables. Finally, the chapter concludes by identifying the knowledge gaps in the
existing research, highlighting the need for this study.

2.2 Theoretical Literature Review

2.2.1 The Phillips Curve and Inflation-Growth Dynamics – A.W Phillips (1958)
The Phillips Curve theory (1958), named after economist A.W. Phillips, posits an inverse
relationship between inflation and unemployment in an economy. Initially observed in
empirical data from the United Kingdom in the 1950s and 1960s, the Phillips Curve suggests

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that as inflation rises, unemployment tends to fall, and vice versa. This relationship implies a
trade-off between inflation and unemployment, often depicted as a downward-sloping curve
on a graph. The Phillips Curve theory, also known as the short-run Phillips Curve, is based on
the idea that in the short term, changes in aggregate demand can influence both inflation and
unemployment. When demand in the economy is high, firms increase production, leading to
lower unemployment but also potentially higher inflation due to increased wages and prices.
Conversely, during periods of low demand, unemployment rises, but inflation tends to
decrease as firms reduce prices to attract customers.

The relevance of the Phillips Curve in this study lies in its implications for monetary policy
and economic stability. While the short-run Phillips Curve may suggest a trade-off between
inflation and unemployment, the long-run Phillips Curve is often depicted as vertical,
indicating that there is no permanent trade-off between inflation and unemployment. Instead,
in the long run, policymakers face a trade-off between inflation and potential output or
economic growth. When inflation exceeds the optimal level, it can have detrimental effects
on economic growth. High inflation erodes the purchasing power of money, distorts price
signals, reduces real wages, and discourages investment. As a result, excessive inflation can
lead to economic instability and hinder long-term growth prospects.

Therefore, policymakers must carefully consider the implications of inflation on economic

growth when formulating monetary policy. While some inflation is necessary for a healthy
economy, central banks aim to maintain price stability by targeting a moderate and stable rate
of inflation conducive to sustainable economic growth.

2.2.2 The Endogenous Growth Theory – Paul Romer (1980s)

The Endogenous Growth Theory, pioneered by economist Paul Romer in the late 1980s and
early 1990s, represents a significant departure from traditional neoclassical growth models.
Romer's theory challenged the notion that technological progress is exogenously determined
and instead emphasized the role of endogenous factors, such as human capital accumulation,
research and development (R&D), and knowledge spillovers, in driving long-term economic
growth. According to Romer, investments in education, training, and skills development
contribute to productivity gains, innovation, and technological progress, driving sustained
economic expansion. Further, technological change is driven by investments in R&D, which
generate new ideas, inventions, and innovations. Unlike traditional growth models that treat
technological progress as exogenous, Romer's model recognizes that R&D activities can be
influenced by economic incentives, government policies, and institutional frameworks.

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Romer emphasized the importance of knowledge spillovers - the diffusion of ideas and
innovations across individuals, firms, and industries - in fostering economic growth.
Knowledge spillovers occur through various channels, including collaboration, imitation, and
competition, and can amplify the impact of technological advancements on productivity and
economic development. Unlike neoclassical growth models, which assume constant returns to
scale, Romer's model incorporates the concept of increasing returns to scale in knowledge-
based industries. This implies that as the level of knowledge and technology grows, the
productivity of inputs increases, leading to self-reinforcing processes of innovation and
growth.

The Endogenous Growth Theory is highly relevant in this study, as it suggests that inflation
impacts key drivers of economic growth, notably investment, productivity, and innovation,
central to Romer's framework. High inflation rates can diminish the real value of savings and
investments, discouraging firms from investing in crucial areas such as physical capital,
research and development (R&D), and human capital formation. This erosion of investment
incentives can constrain long-term growth potential by limiting the accumulation of essential
resources and technological capabilities.

Furthermore, inflation has the potential to distort price signals, leading to resource
misallocation and inefficiencies in labor, capital, and technology allocation. This distortion,
coupled with uncertainty surrounding future inflation rates, can elevate transaction costs and
undermine business confidence, thereby impeding productivity growth. Moreover, inflation
can influence firms' incentives for innovation and R&D investments. Elevated inflation rates
may prompt firms to prioritize short-term profit maximization over long-term innovation, as
the nominal returns from innovative endeavors are eroded by inflation. Additionally,
uncertainty regarding future inflation rates can discourage firms from engaging in long-term
planning and investment in innovative activities.

The Endogenous Growth Theory underscores the multifaceted impact of inflation on

economic growth, highlighting the importance of maintaining price stability and
implementing sound monetary policies to foster sustainable long-term development.

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2.3 Empirical Literature Review

The relationship between inflation and economic growth is complex and varies across
different countries and time periods. While some studies argue for a negative association,
suggesting high inflation hinders growth (Gazi Ercel, 1999), others propose a more nuanced
picture with potential short-term benefits and long-term drawbacks (Estefanía Mourelle &
Iveta Stankovicova, 2016). This review explores recent empirical studies to understand the
complexities of this relationship, particularly focusing on findings relevant to developing
economies like Kenya.

Adaramola and Dada (2020) examined the influence of inflation on the growth prospects of
the Nigerian economy using the the autoregressive distributed lag model. Their analysis,
which employed unit root tests and granger causality covered various variables including,
real GDP, inflation rate, interest rate, exchange rate, degree of economy`s openness, money
supply, and government consumption expenditures spanning from 1980 to 2018. The results
reveal that inflation and real exchange rate negatively affect economic growth, while interest
rate and money supply positively impact it. However, the other variables in the model do not
significantly influence Nigeria's economic growth. Additionally, the causality analysis
indicates unidirectional relationships between interest rate, exchange rate, government
consumption expenditures, and gross domestic product. Consequently, the study suggests that
monetary authorities should implement more effective measures to curb inflation and
maintain a tolerable rate to foster economic growth in Nigeria.

Van Dinh (2020) explored the correlation between the inflation rate and economic growth to
establish the most suitable model for Vietnam's economic development. Employing Vector
Autoregressive (VAR) models, cointegration analysis, and unit root tests on time-series data
spanning from 1996 to 2018, the study aimed to assess the short and long-term effects of
inflation on economic growth. Results indicated that both variables exhibit stationarity at
first-difference I (1) levels, with significance levels at 1%, 5%, and 10%. Moreover, the trace
test revealed the presence of two cointegrating equations at the 0.05 significance level.
Notably, the inflation rate does not Granger cause GDP, indicating a lack of causality between
the two, leading to the recommendation that Vietnam’s monetary authorities should consider
implementing a comprehensive macroeconomic policy to control inflation and stimulate
sustainable growth.

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These above findings are supported by those from Gebeyehu Yismaw (2019), that sought to
investigate whether inflation served as an indicator or a hindrance to Ethiopia's economic
growth. Through pairwise Granger causality tests, the study revealed a strong and significant
correlation between various variables. The test results indicated a unidirectional causation
from real GDP to inflation, real GDP to exports, and real GDP to investment, suggesting that
economic growth influenced these variables. Further, the study hypothesis on whether
inflation causes economic growth or vice versa, with the Granger causality test, demonstrated
a unidirectional causation from economic growth to inflation. While economic growth was
found to lead to inflation, inflation did not drive economic growth during the study period
from 1975 to 2016 in Ethiopia. These findings underscored the importance of aligning
economic growth targets with monetary policy objectives to foster growth and regulate
inflation levels effectively.

Estefanía Mourelle and Iveta Stankovicova (2016) explored the correlation between inflation
and economic growth across six European countries during the period 1991-2015. Their
study aimed to identify the presence of this relationship within these countries, and discern
potential variations in how inflation affects economic growth among these diverse countries,
each with its unique characteristics. The findings of their cointegration analysis, revealed a
positive long-term relationship across all countries, while the short-term dynamics of
economic growth exhibited nonlinearity. Based on these results, there is evidence on the
pivotal role that prices of goods and services play in shaping the trajectory of any economy.
Furthermore, deviations from equilibrium not only influence the structure of economic
growth but also serve as primary catalysts for nonlinear fluctuations in GDP. The researchers
recommend that policymakers must closely monitor deviations from equilibrium and the
movement of prices to foster sustained economic growth.

A different study was conducted in Vietnam to determine the relationship between inflation
and economic growth and identify the optimal inflation threshold for economic growth was
conducted. Van Dinh (2020b) utilized ordinary least squares (OLS) and ordinal regression
models with time-series data from 1996 to 2017 to analyze the relationship over the short and
long term. The sample data fits the models and shows statistical significance. The findings
revealed a close correlation of 96.6% between inflation rate and economic growth, with an
optimal inflation threshold of 4.5% conducive to economic growth. This optimal threshold
served as a basis for fostering economic growth, as inflation rate is positively associated with
economic growth. The findings support the adoption of suitable monetary policy measures by

13
policymakers to manage macroeconomic, monetary, and fiscal policies effectively, ensuring
inflation regulation and sustainable growth. Emphasis is placed on maintaining inflation
stability at the optimal threshold rather than prioritizing long-term economic growth alone.

Sadeghi & Kalmarzi (2023) examined the relationship between inflation and economic
growth in Middle Eastern countries from 2000 to 2021 using a threshold panel model. The
empirical results indicate a nonlinear correlation between inflation and economic growth in
these nations. Specifically, when inflation remains below 10.1 percent, its impact on
economic growth is not significant. However, once inflation surpasses this threshold, it
exhibits a notable negative effect on economic growth. Elevated inflation, by elevating
inflation expectations, may elevate production costs and hinder production and economic
expansion. Additionally, heightened inflation contributes to increased volatility in inflation
expectations, fostering uncertainty in investment and production. This uncertainty erodes
confidence in government policies, potentially undermining the effectiveness of monetary
and fiscal measures. Moreover, high inflation diminishes the competitive advantage of
domestic producers against their foreign counterparts, leading to reduced exports and
ultimately hampering economic growth.

Priscilla Dorothy anak Impin and Sook Ching Kok (2021) investigated the impact of the
inflation rate, interest rate, and unemployment rate on Malaysia's economic growth from
2010 to 2018. Using the Autoregressive Distributed Lag (ARDL) method for cointegration
analysis, their study assessed the long-run and short-run relationships among these variables
and their influence on gross domestic product (GDP). The findings revealed that in the long
run, inflation rate positively affects economic growth, while the interest rate exhibits a
negative impact. However, no long-run relationship is observed between the unemployment
rate and economic growth. Furthermore, employing the Toda-Yamamoto causality test, the
study identified a unidirectional causal link from economic growth to the unemployment rate.

Adeyemi (2019) investigated the impact of inflation and unemployment on economic growth
in Nigeria from 1980 to 2019. Utilizing secondary data sourced from the Central Bank of
Nigeria and the World Bank, the study employed the Augmented Dickey-Fuller and Phillips-
Perron tests to assess data stationarity. Both the long-run and short-run impacts of inflation
and unemployment on economic growth were analyzed using the Autoregressive Distributive
Lag Long Run Coefficient and Error Correction Model, respectively. Additionally, Granger
Causality analysis was employed to ascertain the direction of causality among the variables.

14
The study results indicated that all variables were stationary at first difference, with the co-
integration test confirming their long-run relationship. Specifically, inflation demonstrated a
positive but statistically insignificant impact on Nigeria's economic growth (β=0.1864,
P>0.05), while unemployment exhibits a negative and statistically insignificant impact (β=-
0.0769, P>0.05). The Granger causality analysis suggested that inflation causes economic
growth, whereas unemployment does not influence economic growth in Nigeria during the
study period. Consequently, the study recommended government intervention to establish
additional industries to boost employment, enhance productivity, foster economic growth,
and mitigate inflationary pressures.

Sanga et al. (2023) investigated the impact of inflation on economic growth in Tanzania.
Utilizing secondary time series data spanning from 1970 to 2020 sourced from the Bank of
Tanzania, the study employed the Vector Error Correction Model (VECM) to analyze
cointegration and examine both short-run and long-run dynamics. Graphical analysis and
Augmented Dickey-Fuller tests were conducted to assess the presence of unit roots in the
model, revealing that all variables exhibited stationarity and were integrated at the same
order, I (1). These results indicated a significantly negative error correction term, implying an
annual adjustment rate of 28.31 percent required to achieve long-run equilibrium. In the short
run, the extended money supply and interest rates showed negative and statistically
insignificant effects on GDP, while the exchange rate demonstrated a statistically significant
inverse impact on GDP. Inflation targeting exhibited a favorable but statistically insignificant
effect on GDP. In the long run, the extended money supply, exchange rates, and interest rates
demonstrated positive and statistically significant effects on economic growth, whereas
inflation targeting shows a negative and statistically significant impact on GDP. The study
recommended that government, policymakers, and financial institutions focus on managing
inflation through the prudent implementation of fiscal and monetary policies. It emphasized
the importance of regulating interest rates, the extended money supply, and real exchange
rates, while also highlighting the need for effective inflation targeting through improved
central bank communication, transparency, and accountability to mitigate inflation volatility
and stimulate economic growth.

Marzouk and Oukhallou (2017) investigated the relationship between inflation and the
economy of Suriname from 1975 to 2015, employing a vector autoregressive model and
impulse response functions. The study uncovered that domestic price shocks and money-
supply shocks appeared to significantly affect economic activity, while exchange-rate shocks

15
negatively impacted domestic prices. Based on these findings, the study strongly
recommended that the Central Bank of Suriname continue to implement prudent monetary
policies to maintain exchange rate stability and price stability. The study underscored the
importance of maintaining a healthy macroeconomic environment with stable prices, which is
essential for Suriname to pursue sustained economic growth and development.

Muhammad (2023) investigated the effects of unemployment and inflation on economic

growth. Using regression analysis, the results indicated a positive and statistically significant
coefficient for inflation, highlighting its substantial impact on economic growth. This
underscored the importance of managing inflationary pressures to support sustainable
economic development effectively. However, the analysis found that while unemployment
was positively correlated with economic growth, it lacked statistical significance, suggesting
that unemployment's influence on economic growth is relatively minor compared to factors
like inflation. The findings further, emphasized the need for policymakers to prioritize
addressing inflationary trends. By implementing effective monetary policies and measures to
control inflation, policymakers can foster an environment conducive to investment,
productivity, and overall economic stability.

Romdhane et al. (2023) assessed the impact of inflation targeting on economic growth and
financial stability across 35 emerging economies. These included 19 countries with inflation
targeting policies and 16 without such policies, spanning the period from 1995 to 2017. The
study employed the Qualitative Comparative Analysis method to identify the prerequisites
necessary for adopting the inflation targeting regime, and analyzed the effects of shocks on
economic growth and financial stability in both inflation-targeting and non-inflation-targeting
countries using a Panel VAR model estimated through the GMM method. The findings
suggested that specific structural and institutional preconditions were essential during the pre-
adoption phase. Further, the results indicated that inflation-targeting regimes enabled
emerging economies to better manage economic growth and financial stability in response to
shocks compared to non-targeting countries. However, the study noted that the impact of
shocks tends to be short-term, as economic and financial conditions returned to normalcy in
the long run.

2.4 Conceptual Framework

A conceptual framework provides a visual representation of the anticipated relationship

among the variables under investigation in a research study. It serves as a guide for

16
researchers in exploring the interconnection between the independent and the dependent
variables.
Figure 2.1 illustrates the conceptual framework that will inform this study.

Figure 2.1: Conceptual Framework

Independent Variable Dependent Variable

Inflation
Economic Growth
Consumer prices (annual %)
GDP growth rate (annual %)
Inflation rate (%)

Intervening Variable

Monetary Policy

In the conceptual framework above, the inflation variable will be proxied by changes in the
annual consumer price indices, obtained from World Bank data, representing the independent
variable of the study. Meanwhile, the study's dependent variable will be proxied by the annual
GDP growth rate changes. The effect of inflation on Kenya’s economic growth will be
examined within the context of existing monetary policies, which serve as the intervening
variable in the study.

17
2.5 Summary of Empirical Literature Review and Existing Knowledge Gaps

This section summarizes the key findings from the reviewed empirical literature on the relationship between inflation and economic growth. It
also identifies areas where current knowledge is limited, highlighting the gaps this study aims to address.

Author(s) & Year Title of the Study Research Methodology Key Research Findings Existing Knowledge Gaps Focus of Current Study

Adaramola & Dada Influence of Autoregressive - Inflation & real exchange Limited understanding of Inflation's effect on Kenya's
(2020) Inflation on the Distributed Lag Model rate negatively affect growth other variables' influence growth considering country-
Growth Prospects - Interest rate & money specific factors
of the Nigerian supply positively affect
Economy growth
Van Dinh (2020) Correlation VAR Models, - Inflation & GDP exhibit Optimal inflation threshold Optimal inflation threshold for
Between Inflation Cointegration Analysis stationarity at I(1) - No for growth not explored Kenya's growth
Rate and Economic Granger causality from
Growth in Vietnam inflation to GDP

Gebeyehu Yismaw Does Inflation Granger Causality Tests - Unidirectional causality Limited research on policy Policy recommendations for
(2019) Hinder or Indicate from GDP to inflation - implications Kenya based on growth-
Economic Growth Inflation doesn't drive GDP inflation dynamics
in Ethiopia? growth
Mourelle & Correlation Cointegration Analysis - Positive long-term Limited research on short- Short-term inflation-growth
Stankovicova (2016) Between Inflation relationship between term country-specific dynamics in Kenya
and Economic inflation & growth (Europe) dynamics
Growth in Europe
Van Dinh (2020b) Optimal Inflation OLS & Ordinal - 96.6% correlation between Limited research on optimal Optimal inflation threshold for
Threshold for Regression Models inflation & growth - Optimal thresholds across economies Kenya's growth
Economic Growth threshold: 4.5%
in Vietnam

Sadeghi & Kalmarzi Inflation and Threshold Panel Model - Nonlinear relationship Limited research on Threshold analysis for Kenya
(2023) Economic Growth between inflation & growth - thresholds in developing considering its economic
in Middle Eastern Threshold: 10.1% inflation economies context
Countries for negative growth impact
Impin & Kok (2021) Impact of Inflation ARDL Cointegration - Long-run: Inflation (+) & Limited research on Long-run effect of

17
 Rate, Interest Rate, Analysis Interest Rate (-) impact unemployment's long-run unemployment on Kenya's
and Unemployment growth effect growth
on Malaysia's
Economic Growth
Adeyemi (2019) Impact of Inflation ARDL & Granger - Inflation & Unemployment Limited research on Causality between
and Unemployment Causality have insignificant effects on direction of causality inflation/unemployment &
on Economic growth growth in Kenya
Growth in Nigeria
Sanga et al. (2023) Impact of Inflation Vector Error Correction - Short-run: Inflation Limited research on policy Inflation targeting & growth
on Economic Model targeting has positive but recommendations for policy recommendations for
Growth in Tanzania insignificant effect on GDP African economies Kenya

Marzouk & Oukhallou The Relationship Vector Autoregressive - Domestic price & money Limited research on policy Policy recommendations for
(2017) Between Inflation Model supply shocks affect implications for small Kenya's central bank to
and the Economy of economic activity economies manage inflation
Suriname

Muhammad (2023) Effects of Regression Analysis - Inflation has a positive & Limited research on Policy recommendations for
Unemployment and statistically significant prioritizing inflation control Kenya to prioritize inflation
Inflation on impact on growth control
Economic Growth

Romdhane et al. (2023) Impact of Inflation Qualitative Comparative - Inflation targeting Limited research on inflation Effectiveness of inflation
Targeting on Analysis & Panel VAR improves response to shocks targeting's effectiveness in targeting for Kenya's growth
Economic Growth in emerging economies Sub-Saharan Africa & stability
and Financial
Stability

18
 CHAPTER THREE: METHODOLGY
3.1 Introduction
This chapter outlines the research methodology that will be adopted for the study, detailing
the processes and approaches that will be used to achieve the research objectives. It
encompasses the study’s theoretical framework, research design, data sources, and methods
of data collection, as well as the analytical techniques that will be employed to evaluate the
effects of inflation on economic growth in Kenya. The chapter will also explain the rationale
behind the choice of the Autoregressive Distributed Lag (ARDL) model, the steps that will be
involved in conducting unit root and co-integration tests, and the statistical tools and software
that will be used. Ultimately, this section will provide a clear framework for how the
empirical analysis will be conducted to ensure the accuracy, reliability, and validity of the
study’s findings.

3.2 Theoretical Framework

Phillips Curve Theory: The Phillips Curve suggests a short-run trade-off between inflation
and unemployment, implying that lower inflation may come at the cost of higher
unemployment, and vice versa. This theory will be used to contextualize the inflation-growth
trade-offs in Kenya’s economy.

Endogenous Growth Theory: This theory posits that economic growth is primarily driven by
internal factors such as human capital, innovation, and policy choices rather than external
shocks. This will be relevant in understanding how inflation, as a monetary policy outcome,
impacts Kenya's long-term growth prospects.

3.3 Research Design

This study will adopt a quantitative research design, utilizing time-series econometric
methods to empirically investigate the effect of inflation on economic growth in Kenya.
Secondary data on inflation and GDP obtained from authorized sources will be employed, to
determine the relationship between inflation and economic growth over the period 1990-
2023. The theoretical frameworks underpinning this study include the Phillips Curve, which
posits an inverse relationship between inflation and unemployment, and the Endogenous
Growth Theory, which emphasizes the role of economic policies and innovations in driving
long-term economic growth. These theories will guide the selection of variables and model
specification. The study will employ the Autoregressive Distributed Lag (ARDL) model and
will begin by conducting a unit root test on the variables to assess their stationarity.

19
3.4 Model Specification
To estimate the threshold level of inflation and its effect on economic growth, the study will
adopt the Hansen’s (2000) Threshold Model. This model allows the identification of a
threshold point beyond which inflation significantly affects GDP growth.

The basic specification of the model is as follows:

GDPt =α + β1 . Inflation . I ( Inflation ≤ Ƭ ¿+β 2 . Inflation .I ( Inflation>Ƭ ¿+γ . X t + εt ....... (1)

Where:

 GDPt is the real GDP growth rate in year t,

 Inflationt is the inflation rate in year t,
 I (⋅) is an indicator function that splits the inflation rate into two regimes: below (≤)
and above (>) a certain threshold τ,
 Xt is a vector of control variables (e.g., exchange rates, government spending, interest
rates),
 τ is the threshold level of inflation,
 εt is the error term.
The Hansen Threshold Model will allow the study to empirically determine the inflation rate
at which the effect on GDP changes, providing insight into the "optimal" inflation rate for
economic growth in Kenya.

3.5 Diagnostic Tests

Unit Toot Tests
Macroeconomic variables are commonly characterized by their random walk behavior, which
can be addressed by converting the data to first differences. According to Datta and Kumar
(2011), regressing one non-stationary series on another can lead to misleading or spurious
results. To prevent this issue, the Augmented Dickey-Fuller (ADF) test, introduced by Dickey
and Fuller (1979), will be employed. This test is essential as it informs the selection of the
appropriate estimation techniques for the analysis. The trend and intercept components of the
unit root are shown in equations (3) and (4), respectively.

∆ Yt =β0 + λ Yt-1 + βi ∆ Yt-1 +μti ....... (2) for intercept

∆ Yt =β0 + λ Yt-1 +βit + βi ∆ Y t-1+μti ....... (3) for trend

Where:

20
 t Y is the tested variable for unit root,
Δ is the first difference,
ti μ denotes error term at period i,
t 1 Y − represents the one period lag of the tested variable for unit root.
The Null Hypothesis (H₀) in the ADF test assumes that the time series data is non-stationary
and is defined as follows:

H₀: The time series data is non-stationary.

Hₐ: The time series data is stationary.
This study will apply the ADF test to detect the presence of unit roots in the model, with the
objective of either "rejecting" or "failing to reject" the Null Hypothesis.

3.6 Estimation Techniques

Autoregressive distributed lag (ARDL)

Autoregressive Distributed Lag (ARDL) model will be applied after the Augmented Dickey-
Fuller (ADF) unit root test, and cointegration tests results give optimal results. The ARDL
approach is particularly useful when variables in a time series are stationary at level (I(0))
while others are stationary at first difference (I(1)). The graphical analysis provides an initial
visual insight into the trend and relationship between variables, while the ADF unit root test
confirms the stationarity of the data.

Granger Causality Test

Finally, cointegration tests will be performed to establish whether a long-term equilibrium
relationship exists among the variables, justifying the use of the ARDL model for further
empirical investigation. To investigate the causal relationship between inflation and economic
growth, the study will employ a Granger Causality Test within ARDL. The test will determine
whether past values of inflation can predict GDP growth and vice versa.

3.7 Data Collection and sources

The study will rely on secondary time-series data covering the period from 1990 to 2023. The
data will be sourced from reputable and publicly accessible databases to ensure accuracy and
reliability. Data on GDP growth rates and inflation will be sourced from Kenya National
Bureau of Statistics (KNBS), whereas data on inflation rates, interest rates, and exchange
rates will be sourced from Central Bank of Kenya (CBK). Supplementary macroeconomic

21
data on Kenya’s economic indicators will be sourced from the World Bank and IMF
Databases.

3.8 Data Analysis

The analysis will be conducted using STATA software, chosen for its accuracy and its
capability to handle multivariate analysis, manage data, and generate graphical visualizations
of the study’s empirical findings.

22
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