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Determinants of inflation in Kenya and the 

moderating effects of governance regimes. 
 

 

 

Maonga, Solomon Atura 

Strathmore Business School  

Strathmore University   

 

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DETERMINANTS OF INFLATION IN KENYA AND THE 

MODERATING EFFECTS OF GOVERNANCE REGIMES 

 

 

Solomon Atura Maonga 

Admission No: MDF/66134/18 

 

 

 

 

 

 

A Dissertation submitted to the Strathmore University Business School in 

partial fulfilment of the requirements for the Degree of 

Master of Science (MSc) in Development Finance of Strathmore University 

 

Strathmore University Business School 

Strathmore University 

Nairobi, Kenya 

 

August 2022 

  





ii 

 

ABSTRACT 

A high level of inflation is undesirable because it causes a depreciation of the local 

currency. It also makes long-term financial planning difficult for market participants 

resulting in an inefficiency in a market economy, and subsequently, a lower rate of 

economic growth. An ideal economy would have price stability (low and steady 

inflation) and the wider economic goal of strong and sustainable growth and 

employment would be achieved. This study examined monetary and non-monetary 

determinants of inflation in Kenya, a developing country with a monetary policy 

objective of inflation-targeting. Using an Error Correction Model (ECM) based on the 

Autoregressive Distributed Lag (ARDL) model to explain the short run and long run 

impacts of each variable on inflation, this study covered secondary quarterly data 

spanning 25 years (1996 – 2020). The unique contribution of the study was the 

investigation of the moderating effects of governance regimes on the determinants of 

inflation. Governance regimes were examined with respect to the President of the 

country and the Central Bank Governor. The study concluded that in the Kenyan 

context, inflation is primarily influenced by prevailing interest rates and the most 

recent rates of inflation in the short run. The non-monetary factors and other monetary 

factors examined do not have a long run nor short run impact on the level of inflation, 

but given the moderating effects of governance regimes, their influence may be felt 

sporadically. Global oil prices and public debt levels are emerging as major factors 

influencing the rate of inflation. The study emphasises the importance of good 

governance to ensure consistency of policy across regimes in order to maintain price 

stability. 

Key words: ARDL model, inflation-targeting, price stability, monetary 

determinants, non-monetary determinants and governance regime. 

  



iii 

 

TABLE OF CONTENTS 

DECLARATION ......................................................................................................... i 

ABSTRACT ................................................................................................................ ii 

LIST OF FIGURES ................................................................................................. vii 

LIST OF ABBREVIATIONS AND ACRONYMS .............................................. viii 

DEFINITION OF TERMS ....................................................................................... ix 

ACKNOWLEDGEMENT ........................................................................................ xi 

DEDICATION .......................................................................................................... xii 

CHAPTER 1: INTRODUCTION ............................................................................. 1 

1.1. Introduction ......................................................................................................... 1 

1.2. Background .......................................................................................................... 1 

1.2.1. Inflation and Monetary Policy in Developing Countries ................................... 1 

1.2.2. Understanding Inflation and its Determinants .................................................. 2 

1.2.3. Significance of Inflation ..................................................................................... 5 

1.2.4. Deflation and Zero Inflation .............................................................................. 9 

1.2.5. Inflation-targeting in Kenya ............................................................................. 10 

1.3. Problem Statement ............................................................................................ 13 

1.4. Research Objectives .......................................................................................... 15 

1.5. Research Questions ........................................................................................... 15 

1.6. Scope of Study ................................................................................................... 15 

1.7. Significance of the Study .................................................................................. 16 

1.7.1. Households ....................................................................................................... 16 

1.7.2. Firms ................................................................................................................ 17 

1.7.3. The government ................................................................................................ 17 

1.7.4. Investors ........................................................................................................... 18 

1.7.5. Academia and Policy Makers .......................................................................... 18 

CHAPTER 2: LITERATURE REVIEW ............................................................... 19 

2.1. Introduction ....................................................................................................... 19 

2.2. Theoretical Review ............................................................................................ 19 



iv 

 

2.2.1. Monetary Perspective ...................................................................................... 20 

2.2.2. Non-monetary Perspective ............................................................................... 23 

2.2.3. Hybrid Models .................................................................................................. 26 

2.2.4. Heterodox views ............................................................................................... 26 

2.3. Empirical Review .............................................................................................. 28 

2.3.1. Monetary Factors and Inflation ....................................................................... 28 

2.3.2. Non-Monetary Factors and Inflation ............................................................... 31 

2.3.3. Governance Regimes and Inflation .................................................................. 33 

2.4. Summary of the Reviewed Literature and Research Gap ............................ 34 

2.5. Conceptual Framework .................................................................................... 35 

CHAPTER 3: RESEARCH METHODOLOGY .................................................. 38 

3.1. Introduction ....................................................................................................... 38 

3.2. Research Philosophy ......................................................................................... 38 

3.3. Research Design ................................................................................................ 38 

3.4. Data Collection .................................................................................................. 39 

3.5. Data Analysis ..................................................................................................... 40 

3.5.1. The Approach to the Analysis .......................................................................... 40 

3.5.2. The ARDL Model ............................................................................................. 41 

3.5.3. The Model Specifications ................................................................................. 41 

3.6. Descriptive Statistics ......................................................................................... 44 

3.7. Diagnostic Tests ................................................................................................. 44 

3.7.1. Tests for Stationarity ........................................................................................ 44 

3.7.2. Lag Selection for the ARDL Model .................................................................. 45 

3.7.3. Other Diagnostic Tests ..................................................................................... 45 

3.8. Research Quality ............................................................................................... 46 

3.8.1. Data Validity .................................................................................................... 46 

3.8.2. Research Reliability and Objectivity ................................................................ 47 

3.9. Ethical Issues in Research ................................................................................ 48 

CHAPTER 4: PRESENTATION OF RESEARCH FINDINGS ......................... 49 



v 

 

4.1. Introduction ....................................................................................................... 49 

4.2. Sample Representation ..................................................................................... 49 

4.3. Descriptive Statistics ......................................................................................... 49 

4.4. Correlation Analysis ......................................................................................... 51 

4.5. Moderation Analysis ......................................................................................... 52 

4.6. Diagnostic Tests ................................................................................................. 52 

4.6.1. Test for Normality ............................................................................................ 52 

4.6.2. Test for Serial Correlation ............................................................................... 53 

4.6.3. Test for Heteroscedasticity ............................................................................... 53 

4.6.4. Test for Multicollinearity ................................................................................. 54 

4.6.5. Test for Causality ............................................................................................. 54 

4.7. The ARDL Analysis .......................................................................................... 56 

4.7.1. Optimal Lags .................................................................................................... 56 

4.7.2. Test for Stationarity.......................................................................................... 56 

4.7.3. Estimating the Model ....................................................................................... 57 

4.7.4. Bounds Cointegration Test ............................................................................... 59 

4.7.5. Estimation of Error Correction Model ............................................................ 60 

CHAPTER 5: DISCUSSION, CONCLUSIONS AND RECOMMENDATIONS

 .................................................................................................................................... 64 

5.1. Introduction ....................................................................................................... 64 

5.2. Discussion of Findings ...................................................................................... 64 

5.2.1. The Monetary Determinants of Inflation in Kenya .......................................... 64 

5.2.2. The Non-Monetary Determinants of Inflation in Kenya .................................. 65 

5.2.3. The Moderating Effect of the Governance Regime .......................................... 65 

5.3. Conclusions ........................................................................................................ 66 

5.4. Recommendations ............................................................................................. 68 

5.5. Limitations of the Study ................................................................................... 69 

5.6. Recommendations for Further Studies ........................................................... 70 

References ................................................................................................................. 72 



vi 

 

Appendices ................................................................................................................ 77 

Appendix 1: Letter of Introduction ............................................................................. 77 

Appendix 2: Ethical Review Committee Approval ..................................................... 78 

Appendix 3: Research License from NACOSTI ......................................................... 79 

Appendix 4: The Presidents and Central Bank Governors since Independence ....... 80 

Appendix 5: Descriptive Statistics ............................................................................. 81 

Appendix 6: Comparison of Information Criteria for Lag Selection ......................... 83 

Appendix 7: Optimal Lag Structure for ARDL Regressions with Interaction Terms 84 

Appendix 8: ECM Output for the Presidents ............................................................. 85 

Appendix 9: ECM Output for the CBK Governors .................................................... 86 

Appendix 10: Shapiro-Wilks Test Results on all Variables ....................................... 88 

 

  



vii 

 

LIST OF FIGURES 

Figure 1: Trend of the Rate of Inflation in Kenya ..................................................... 11 

Figure 2: Conceptual Framework ............................................................................. 35 

Figure 3: Operationalisation of the Variables........................................................... 36 

Figure 4: Decision-making criteria for Moderation Analysis ................................... 44 

Figure 5: Descriptive Statistics for Monetary and Non-Monetary Factors .............. 50 

Figure 6: Correlation Matrix of the Monetary and Non-Monetary Variables .......... 51 

Figure 7: Results of ANCOVA Analysis ..................................................................... 52 

Figure 8: Results of Shapiro-Wilks Test .................................................................... 53 

Figure 9: Results of the White's Test .......................................................................... 54 

Figure 10: Results of Variance-Inflation Factor ....................................................... 54 

Figure 11: Results of the Granger causality Wald test .............................................. 55 

Figure 12: ADF Test Results of Monetary and Non-Monetary Variables ................. 56 

Figure 13: ADF Test Results at First Difference ....................................................... 57 

Figure 14: Optimal Lags for Bounds Cointegration Test .......................................... 57 

Figure 15: Output for ARDL (4 0 0 1 0 0 0) Regression ........................................... 58 

Figure 16: Comparative ARDL Output for the Various Governance Regimes ......... 59 

Figure 17: Bounds Cointegration Test Output .......................................................... 60 

Figure 18: Error Correction Model (ECM) Output .................................................. 61 

 

  



viii 

 

LIST OF ABBREVIATIONS AND ACRONYMS 

ARDL  - Autoregressive Distributed Lag Model 

ADF  - Augmented Dickey-Fuller Test 

AIC  - Akaike Information Criterion 

ARDL  - Autoregressive Distributed Lag Model 

CBK  - Central Bank of Kenya 

CMA  - Capital Markets Authority 

CPI  - Consumer Price Index 

ECM  - Error Correction Model 

EDF  - Empirical Distribution Function 

GDP  - Gross Domestic Product 

HIC  - Hannan-Quinn Information Criterion 

IMF  - International Monetary Fund 

IRA  - Insurance Regulatory Authority 

KIPPRA - Kenya Institute of Public Policy Research and Analysis 

KNBS  - Kenya National Bureau of Statistics 

KRA  - Kenya Revenue Authority 

MPC  - Monetary Policy Committee (of the Central Bank of Kenya) 

NSE  - Nairobi Securities Exchange 

OLS  - Ordinary Least Squares Regression Method 

OMO  - Open Market Operations 

RBA   - Retirement Benefits Authority 

SASRA - Sacco Societies Regulatory Authority 

SBIC  - Schwarz Bayesian Information Criterion 

  



ix 

 

DEFINITION OF TERMS 

Deflation A sustained decline in the price level (Blanchard, 2017). It is 

the opposite of inflation. It may also be referred to as 

negative inflation.  

Degrees of freedom The number of values free to vary when computing a 

statistic. The number of degrees of freedom for a 

contingency table of at least two rows and 2 columns of data 

is calculated from: (number of rows in the table – 1) * 

(number of columns in the table – 1) (Saunders, Lewis and 

Thornhill, 2012). 

Disinflation A slow-down in the rate of inflation (Blanchard, 2017). 

Hyperinflation 
Instances of extraordinarily high inflation (Mankiw, 2010). 

This is an extremely high cost of living for residents in an 

economy. 

Inflation 
A sustained rise in the general price level (Blanchard, 2017). 

It is a macroeconomic variable used to analyse the state of an 

economy. 

Inflation-targeting A monetary policy strategy that entails seeking to achieve a 

certain target for the level of inflation for an economy over a 

specified period, with an objective of anchoring long-term 

inflation expectations. This approach is characterized, as the 

name suggests, by the announcement of official target ranges 

for the inflation rate at one or more horizons, and by explicit 

acknowledgment that low and stable inflation is the 

overriding goal of monetary policy (Bernanke and Mishkin, 

1997). 

Monetary 

determinants 

For the purpose of this study, these are factors linked to 

monetary policy transmission. These include interest rates, 

exchange rates and money supply. 



x 

 

Non-monetary 

determinants 

For the purpose of this study, these are all other factors that 

do not relate to monetary policy transmission. These include 

food prices, oil prices (energy costs), imported inflation and 

inflation expectations. 

Stagflation A situation that combines economic stagnation (falling 

output) with inflation (rising prices) (Mankiw, 2009). The 

stagnation referred to is slow economic growth. 

  



xi 

 

ACKNOWLEDGEMENT 

I am forever grateful to the faculty and the entire Strathmore University Business 

School for their continued support during the duration of the course. I would like to 

acknowledge and thank my supervisor Dr. Thomas Kibua for providing invaluable 

guidance throughout the study. I would also like to extend my gratitude to my 

classmates in the Master of Science in Development Finance class who provided 

encouragement, and to my family members, work colleagues and friends for their 

continued immense support and encouragement throughout my studies. Lastly, I am 

grateful to the almighty God for the grace to successfully undertake the research 

dissertation. 

 

  



xii 

 

DEDICATION 

This work is dedicated to my parents for motivating, inspiring and relentlessly 

encouraging me to go on and complete the Master of Science in Development Finance 

degree. They never wavered. 

 

 



 1 

CHAPTER 1: INTRODUCTION 

1.1. Introduction 

This chapter captures the background of the study, followed by a statement of the 

problem, the research objectives, and the research questions that the study will seek to 

address. The scope of the study will follow thereafter and finally, the justification for 

the study. 

1.2. Background 

1.2.1. Inflation and Monetary Policy in Developing Countries 

Most governments in developing countries are faced with the challenge of facilitating 

development in their economies to tackle their innate problems, key among them, 

poverty eradication. Africa is one continent that plays host to several developing 

countries. Historically referred to as the Dark Continent, Africa has, in recent years, 

had a renewed interest from the developed countries as an investment destination. 

History has shown that countries that focus on building structures can promote their 

own development. A good case of this is the story of the Asian Tigers1 who emerged 

from poverty after the devastating impact of World War II, becoming a phenomenal 

example of consistent growth despite financial crises such as the Asian crisis of 1997 

and the global financial crisis of 2008. 

In sub-Saharan Africa, there is another story – the story of the six African lion 

economies 2  that are among the developing countries that have continued to 

consistently grow at a fast pace. 

Frankel (2010) carried out a survey of monetary policy implementation in emerging 

markets and identified certain distinct challenges for developing countries. To begin 

with, he noted that compared to large industrialized countries, the characteristics that 

distinguish most developing countries, include: greater exposure to supply shocks in 

general and trade volatility in particular; procyclicality of both domestic fiscal policy 

and international finance; lower credibility with respect to both price stability and 

default risk; and other imperfect institutions.  

 
1 Asian Tigers: Hong Kong, Taiwan, Singapore and South Korea 
2 African Lions: Nigeria, South Africa, Ghana, Ethiopia, Mozambique and Kenya 



2 

 

According to Frankel (2010), the exchange rate was the favoured nominal anchor for 

monetary policy in inflation stabilisations of the late 1980s and early 1990s. On 

assessing the exchange rate as the key monetary policy objective, he noted that the 

contractionary effects of devaluation are also far more important for developing 

countries as price-takers on world markets, particularly the balance sheet effects that 

arise from currency mismatch.  

Frankel (2010) noted, however, that after the currency crises of 1994-2001, inflation-

targeting emerged as the preferred monetary regime in place of exchange rate targets. 

The global financial crisis revealed limitations to the choice of CPI for the role of price 

index. 

Emerging economies have struggled to maintain inflation at manageable levels, and 

given that it has a link with sustainable economic growth, it cannot be ignored. 

Ochieng, Mukras and Momanyi (2016) posit that in many sub-Saharan countries, it is 

challenging for monetary authorities to control inflation even if there is a political will, 

due to weak institutional frameworks, thin financial markets and imperfect 

competition among banks. 

1.2.2. Understanding Inflation and its Determinants 

To understand inflation, one must first understand the distinction between price and 

value. Price can be viewed as the measure of the meeting point where a seller and a 

buyer agree to exchange money in order for one to enjoy a certain economic benefit of 

an asset. Value on the other hand can be viewed as the subjective measure of the 

economic benefit of an asset. These manifest within an economy through the infamous 

Law of Supply and Demand. 

Inflation is defined by Blanchard (2017) as a sustained rise in the general price level. 

This is not to be confused with hyperinflation which Mankiw (2010) describes as 

instances of extraordinarily high inflation. Mankiw (2010) identifies the classic 

examples of Germany in 1923, when prices increased an average of 500 percent per 

month and Zimbabwe in 2008 when hyperinflation gripped the nation, reaching a peak 

inflation estimated at 6.5 sextillion percent in mid-November. This resulted in the 

depreciation of the Zimbabwean currency which was resolved by the adoption of the 

US Dollar. 

Deflation is the opposite of inflation and is defined as a sustained decline in the price 

level (Blanchard, 2017). It may also be referred to as negative inflation. A slow-down 

in the rate of inflation is referred to as disinflation. 



3 

 

The measurement of inflation is mainly done through the Consumer Price Index (CPI). 

The CPI measures the cost of a market basket of consumer goods and services relative 

to the cost of that bundle during a particular base year (Samuelson and Nordhaus, 

2010). The constituents of the consumption basket are assumed to be standard over a 

period. As such, the CPI is the most common measure of inflation. In practice, 

however, the consumption basket is likely to evolve over time owing to technological 

advancements and changes in consumer behaviour. These changes could manifest 

through changes in fashion, tastes and preferences. 

From a producer perspective, there also exists another measure known as the Producer 

Price Index (PPI) which measures the average changes of prices of products at all 

stages of production. The intuition behind this is that prices of goods and services are 

majorly determined at the point of production due to the cost of inputs. However, PPI 

does not feature predominantly with reference to the inflation debate as the CPI 

essentially relates to the ultimate price paid by the consumer, which includes taxes. 

Another lesser used measure of inflation is the GDP deflator. The GDP deflator is the 

price of all of the different components of GDP (Samuelson and Nordhaus, 2010). It 

is often taken as the ratio of the nominal GDP to the real GDP. The CPI differs from 

the GDP deflator in that it is based on a particular basket of goods and services; the 

GDP deflator is based on the whole economy. There are numerous other measures of 

inflation3, which speaks to the concern around this macroeconomic phenomenon. 

Inflation is caused by several diverse factors. These could be broadly categorized as 

being either monetary or non-monetary. Monetary factors relate to those linked to 

monetary policy transmission. Inflation is a matter of price, which goes hand-in-hand 

with money, after all. The factors in question include interest rates, exchange rates and 

money supply. 

There is the famous assertion by Friedman (1960) that “inflation is always and 

everywhere a monetary phenomenon”; and, as a result, “no country can succeed in 

stemming inflation without adopting measures directed at restraining the growth of the 

stock of money”. 

Non-monetary factors (all other factors that do not relate to monetary policy 

transmission) include food prices, oil prices (energy costs), imported inflation and 

inflation expectations. There seems to be no consensus as to whether non-monetary 

 
3 For example, wholesale price index (WPI), employment cost index (ECI) and retail prices index 

(RPI) 



4 

 

factors have significant influence on inflation based on available literature, though 

there seems to be a general alignment on monetary factors. The Monetary Policy 

Committee (MPC, 2021), through a white paper published on the Central Bank of 

Kenya (CBK) website (https://www.centralbank.go.ke/modernisation-of-the-

monetary-policy-framework-operations/) identifies external shocks such as the global 

financial crisis and more recently, the global COVID-19 pandemic that create 

uncertainties for economic agents.   

Among the non-monetary factors assessed in this study was the level of debt as 

measured by the debt-to-GDP ratio. In recent years, Kenya has taken on more debt, 

which may have influenced inflationary expectations. The country also issued debt in 

the international markets. A case that illustrates the impact of debt and inflationary 

expectations is when the inaugural five-year Eurobond issued by the country in June 

2014 was due to mature in June 2019, a principal of US$ 750 million. The expectation 

of a significant cash outflow in foreign currency (US Dollars) led to expectations of 

increased inflation. The rate of inflation in April 2019 was at 6.98 percent, but the 

issuance of a new Eurobond in May served to ease expectations as inflation dropped 

to 5.49 percent. It was envisaged that part of the US$ 2 billion Eurobond would offset 

the cash outflow. 

Spratt (2009), while describing Fisher’s explanation of the cause of the Great 

Depression, notes that the increase in borrowing raises the money supply and therefore 

the rate of inflation, and this rise in prices reduces the value of the debt, which 

encourages ever more borrowing. 

In addition to the aforementioned factors, this study investigated the movement of the 

stock market index to establish whether it has a significant influence on the rate of 

inflation. Kenya has a single stock market, the Nairobi Securities Exchange (NSE) 

which could serve as a valuable proxy for the performance of firms, and the economy 

at large.  

A key distinction of the study is the examination of the inflation trends in relation to 

governance regimes. The study examined the moderating effects of the regimes based 

on the presidential regime of the time as well as the central bank governance era for 

the twenty-five-year period. Notably, governance is significant as inflation in Kenya 

has also been affected by political shocks, for example, the political transition of the 

1990s and the post-election violence of 2008 (Gil-Alana and Mudida, 2016). 



5 

 

Given that managing inflation is under the ambit of the duties of the CBK, it would be 

important to examine whether a governance regime has any influence on inflation. 

Governance regime in this study was considered as the period within which a certain 

individual was the central bank Governor or the President of the country. This was a 

fairly novel consideration, and it was examined with a view to establishing whether 

the strategic and political objectives of Central Bank Governors and Presidents have 

had an influence, if at all, on the rate of inflation. 

1.2.3. Significance of Inflation 

Globally, the most common monetary policy objective is a low and stable inflation, or 

simply, price stability. This occurs when the price level does not adversely affect the 

decisions of consumers and producers. Price stability is significant in achieving the 

wider economic goal of strong and sustainable growth and employment. It is important 

for there to be some level of inflation because this ensures that other inflation-

dependent factors are sustained such as a natural rate of employment. 

Other secondary objectives of monetary policy include stability of the financial 

system, economic growth, full employment and stability of the foreign exchange 

markets. Therefore, ultimately, high inflation and deflation are not ideal, but price 

stability is. 

To achieve price stability, monetary policy transmission is conducted via monetary 

policy tools such as open market operations, discount window (also known as standing 

facility), reserve requirements and interest on reserves. Open market operations 

include Repos, Reverse Repos, Term Auction Deposits (TAD), the Central Bank Rate 

(CBR), Horizontal Repos and Foreign exchange market operations. 

There are a number of channels of monetary policy transmission such as the interest 

rate channel, the asset price channel, the exchange rate channel, the credit channel and 

the expectations channel. The expectations channel has emerged as a key channel 

based on the assumption of forward-looking and rational economic agents. The 

expectations channel thrives on enhanced signalling to economic agents. In practice, 

this channel is mainly attributed to developed economies with well-functioning and 

deep financial markets. 

In such economies, expectations of future changes in the policy rate can immediately 

impact medium and long-term interest rates. Monetary policy can also guide economic 

agents’ expectations of future inflation and thus influence price movements. Inflation 



6 

 

expectations matter with regard to the determination of real interest rates as well as 

influencing price- and wage-setting behaviour. 

From the perspective of firms, a high inflation environment is not ideal as it increases 

the cost of debt by increasing the nominal interest rates. This reduces the willingness 

of firms to hire new employees and to spend in general. Firms experience a wealth 

effect as higher interest rates reduce their net worth and worsen their cashflow. High 

inflation also adds pressure to increase the wages of their workforce, thus creating 

uncertainties with regard to labour costs. 

The government as an economic agent is keen to ensure that inflation is well managed, 

especially in the run-up to an election, to minimize dissent. In Kenya, the election cycle 

occurs every five years and this is usually taken into account. In other periods, it is 

important that inflation is maintained within a target for ease of planning and to ensure 

that there is sustained economic growth. 

Unlike fiscal policy whose impact is felt fairly immediately in the economy, monetary 

policy is more gradual. This makes economists consider both short-term and long-term 

rates. It is in this regard that the term structure of interest rates comes to the fore given 

that monetary shocks tend to have a lagging impact on the economy. This relationship 

between interest rates over different horizons is the so-called term structure of interest 

rates which captures the relationship between default-free interest rates that only differ 

in the length of their maturity (Cox, Ingersoll and Ross, 1985). 

The expectations hypothesis of the term structure of interest rates states that the long-

term interest rate is an average of expected future short term interest rates (Mishkin, 

1990). Consequently, lower real short term interest rates lead to a decline in the real 

long-term interest rate. Other theories include the liquidity preference theory (Hicks, 

1946), the market segmentation hypothesis (Culbertson, 1957) and the preferred 

habitat theory (Modigliani and Sutch, 1966). 

According to Cox et al. (1985), in its simplest form, the expectations hypothesis 

postulates that bonds are priced so that the implied forward rates are equal to the 

expected spot rates. Generally, this approach is characterised by the following 

propositions: (a) the return on holding a long-term bond to maturity is equal to the 

expected return on repeated investment in a series of the short-term bonds, or (b) the 

expected rate of return over the next holding period is the same for bonds of all 

maturities.  



7 

 

In developing countries, interest rate movements tend to have a conspicuous signalling 

effect on inflationary expectations owing to the dominance of banking financial 

institutions in the economy. The influence of the same in developed countries is much 

less emphasized as there are deep financial markets with a notable number of non-

bank financial institutions. 

The exchange rate against the major currencies could also cause inflation particularly 

in a country that is a net importer of goods and services. Inflation can also be caused 

by demand-side factors such as the amount of disposable income of economic agents. 

Non-monetary factors also have a part to play with regard to inflation. However, 

existing literature varies depending on the country in question. One of the factors most 

commonly agreed on is inflation expectations which assumes that economic agents 

will act rationally in response to economic events. 

Other factors include food prices and oil prices. These are the main drivers of inflation 

in developing countries. For instance, during periods of drought or excessive rain, the 

prices of food could increase, leading to an increase in the inflation rate.  Fluctuating 

world oil prices could impact inflation, and this would be observed in movements in 

energy costs as well as transport costs.  

Like most macroeconomic variables, inflation is a double-edged sword; there are 

winners and losers. Among those who benefit in times of high inflation are borrowers, 

especially those who borrow for a longer time horizon. Inflation causes a decline in 

the real value of repayments, ceteris paribus. Similarly, those who hold real assets 

such as property and land benefit from the appreciation in real value. Workers who 

have market power are also well-placed to benefit from inflation as they are able to 

negotiate wage increments in line with the shift in purchasing power. This is so 

because for firms, wages – an expense to firms – tend to be relatively static. A key 

objective of firms is to maximise profits. 

On the flip side, one category of losers in the incidence of high inflation are lenders 

who suffer an opportunity cost on their funds and are predisposed to receive lower 

repayments in real terms. Individuals or households with fixed income interest 

investments such as fixed deposits are also likely to suffer a decline in real terms, 

particularly if the rate of their return on investment is lower than inflation. As 

Samuelson and Nordhaus (2010) put it, an unanticipated inflation redistributes wealth 

from creditors to debtors, helping borrowers and hurting lenders; an unanticipated 

deflation has the opposite effect. 



8 

 

Naturally, workers whose incomes do not keep pace with inflation are likely to lose 

out in the instance of a high inflation rate economy. These are often workers without 

enough leverage to negotiate increases to their wages in line with inflation such as 

casual labourers and contract employees. 

The poor also stand to lose in case of hoarding within a high inflation environment. 

Oftentimes, people would buy non-perishable commodities (such as cereals) and other 

goods as stores of wealth (such as gold) to avoid the losses expected from the declining 

purchasing power of money. This in turn creates shortages of the hoarded goods. 

Unlike the rich, the poor would be more vulnerable in such a scenario. 

Blanchard (2017) identifies four main costs of inflation among economists: shoe-

leather costs, tax distortions, money illusion and inflation variability. Shoe-leather 

costs relate to the opportunity cost of trips to access one’s funds from the bank which 

include working more or enjoying leisure. The tax distortions are the result of 

interactions between taxation and inflation among different tax brackets which may 

affect nominal income but not real income – inflation tends to increase the nominal 

income. 

The money illusion arises from not taking into consideration the real value of money 

and assets. This leads economic agents to make incorrect decisions based on the 

illusion of increased value in nominal terms which may not be accompanied by 

increase in real terms. Inflation variability increases the risk of financial assets which 

promise fixed future nominal payments. 

However, Blanchard (2017) also identifies certain benefits of inflation: seignorage; the 

use of the interaction between money illusion and inflation in facilitating real wage 

adjustments; and the option of negative real interest rates for macroeconomic policy. 

Seignorage refers to the process of money creation by central banks issuing treasury 

securities such as bonds through open market operations as an alternative to borrowing 

from the public or raising taxes. 

As for the somewhat paradoxical money illusion interplay with inflation for wage 

adjustments, Blanchard (2017) notes that the constant process of change that 

characterizes modern economies means some workers must sometimes take a real pay 

cut. Thus, the argument is that the presence of a level of inflation allows for these 

downward real wage adjustments more easily than if inflation is equal to zero. So, for 

instance if inflation is 5 percent and nominal wages are increased by 1 percent, the net 

effect is the same as a nominal reduction of 4 percent in an economy with zero 



9 

 

inflation. However, workers would be willing to opt for the first instance. This is 

analogous to the question of whether a kilogram of feathers is heavier than a kilogram 

of steel. Of course, they weigh the same, but there is a psychological inclination to 

believe that the steel is heavier than the feathers. 

From a developmental standpoint, inflation is important to consider for the bottom of 

the pyramid if indeed developing countries are to achieve the goal of eradicating 

poverty. The poor tend to spend a larger share of their meagre incomes on food, and 

as a result, high food prices are likely to affect them more than other segments of the 

population. Additionally, high food prices have the potential to push some lower 

middle-income households back to below poverty lines. 

If a higher inflation rate meant just a faster but proportional increase in all prices and 

wages — a case called pure inflation — inflation would be only a minor inconvenience 

because relative prices would be unaffected (Blanchard, 2017). The challenge with 

pure inflation is that it is virtually impossible – during periods of inflation, prices and 

wages do not rise evenly and inflation leads to other distortions such as increased 

uncertainty which is exacerbated by taxes. 

High levels of inflation inhibit economic growth by causing the local currency to lose 

value relative to international currencies, thereby affecting the competitiveness of local 

goods and services in the global markets. This arises with the increased cost of 

exporting the products to foreign markets. This also makes it difficult for foreign 

investors to make long-term financial decisions owing to uncertainty about the future 

value of their investments and savings (postponed consumption). This translates to 

inefficiency in a market economy and, in the medium to longer term, to a lower rate 

of economic growth. 

1.2.4. Deflation and Zero Inflation 

One might wonder whether deflation (negative inflation) is desirable, given that 

inflation is worrisome. The answer is a resounding ‘no’. A high rate of deflation has 

much of the same effects as high inflation in that it also leads to increased uncertainty 

and has an impact on the effectiveness of monetary policy. 

The crux of the matter is that dynamic changes in the general price level affect the 

economy by increasing uncertainty. Therefore, the ideal scenario is one in which price 

stability is maintained. This is achieved by maintaining a low and steady rate of 

inflation. In an ideal economy, price stability would be present, and the wider 

economic goal of strong and sustainable growth and employment would be achieved. 



10 

 

Why not eliminate inflation altogether? 

A zero-inflation target is idealistic because it assumes a frictionless economy. In 

reality, there are frictions such as the resistance of reductions in wages. Efficient labour 

markets would rebalance such that there would be reductions in some sectors and 

increases in other sectors. Yet workers and firms are extremely reluctant to cut money 

wages. Some economists believe that, in the context of downward rigidity of nominal 

wages, a zero rate of inflation would lead to higher unemployment on average.  

A more grievous concern about zero inflation is that economies might face a liquidity 

trap were they to encounter a major contractionary shock. They might need negative 

real interest rates to climb out of the recession with monetary policy. While fiscal 

policy would still be effective, most macroeconomists believe that a better solution is 

to aim for a positive inflation rate so that the threat of liquidity traps is minimized 

(Samuelson and Nordhaus, 2010). 

The option of negative interest rates speaks to a scenario whereby inflation rates are 

so low that they hamper the influence of monetary policy in fending off a liquidity 

trap. In a high inflation environment, there is more wiggle-room to apply monetary 

policy. This scenario was observed during the global financial crisis whereby banks in 

developed countries were avoiding lending to the market and then had to allow for 

negative interest rates. 

This also manifested globally more recently with the onset of the COVID-19 pandemic 

in 2020. The Kenyan banks responded by restricting credit to borrowers on account of 

the uncertainty that prevailed. 

1.2.5. Inflation-targeting in Kenya 

In this study, the researcher examined the dynamics of inflation in Kenya, a developing 

country located in sub-Saharan Africa. Over the last two and a half decades, the 

monetary policy framework in Kenya has evolved from a purely monetary aggregate 

targeting framework towards a more forward-looking framework (MPC, 2021). The 

MPC defines the forward-looking monetary policy framework (inflation-targeting) as 

a strategy that communicates a numerical target for the level of inflation over a 

specified period, with an objective of anchoring long-term inflation expectations. 



11 

 

 

Figure 1: Trend of the Rate of Inflation in Kenya 

Source: Author computation 

From Figure 1, it is evident that inflation had been extremely volatile in the earlier 

years but has largely been tamed over time.  

As observed from historical KNBS data, Kenya has had an average annual inflation 

rate reach as high as 54.52 percent in March 1984. In the period after the global 

financial crisis, inflation peaked at 15.96 percent in March 2009 and reached as low as 

3.18 percent in October 2010. The MPC identifies the gradual decline in inflation in 

Kenya with better macroeconomic management; falling from the double digits 

witnessed in the 1990s to average 8.6 percent in 2000-2009, 7.1 percent in 2010-2019 

and 5.5 percent in 2020-2021 (MPC, 2021). 

According to Mishkin (2001), inflation-targeting encompasses five main elements: the 

public announcement of medium-term numerical targets for inflation; an institutional 

commitment to price stability as the primary goal of monetary policy, to which other 

goals are subordinated; an information inclusive strategy in which many variables, and 

not just monetary aggregates or the exchange rate, are used for deciding the setting of 

policy instruments; increased transparency of the monetary policy strategy through 

communication with the public and the markets about the plans, objectives, and 

decisions of the monetary authorities; and increased accountability of the central bank 

for attaining its inflation objectives. 

According to the website of the CBK (https://www.centralbank.go.ke/our-mission/), 

its principal objective is the formulation and implementation of monetary policy 

0.00%

4.00%

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12-Month Rate of Inflation



12 

 

directed towards achieving and maintaining stability in the general level of prices (low 

and stable inflation). 

In the Kenyan monetary policy framework, the ultimate objective is to manage 

headline inflation. Kenya targets an inflation rate of between 2.5 percent and 7.5 

percent. The psychological median of 5 percent is a key consideration as any rate above 

5 percent is likely to be worrisome to the participants in the economy. 

The intermediate target is to manage inflation forecasts and expectations whereas the 

operational target is to control the overnight interbank rate through the central bank 

rate. While inflation-targeting has the advantage of transparency and accountability in 

an attempt to attain the target level of inflation, it could also present the challenges of 

delayed signalling because of the lags in monetary policy transmission and low 

economic growth as a result of low inflation. 

Historically, Kenya had experienced low rates of inflation since independence in 1963 

which began to rise in the late 1970s. This rise was mainly attributed to poor rainfall, 

global world recession and the oil crisis due to increasing oil imports as the oil prices 

rose (Kirimi, 2014). An oil shock and an attempted coup in 1982 eroded investor 

confidence and resulted in capital flight, leading to a rise in inflation. 

The transition to an inflation-targeting framework began in 1993 on the backdrop of a 

high-inflation economic environment. The high inflation rate was mainly attributed to 

the low investor confidence owing to the transition to multi-party politics in 1992. The 

inflation-targeting monetary policy has been implemented since then with certain 

modifications. 

The MPC (2021) notes that prior to 2008, the conduct of monetary policy was based 

entirely on a monetary aggregate targeting framework which later became unreliable 

owing to the rapid deepening of the financial markets, increased use of electronic 

payment systems over cash and a deepening of financial inclusion. Therefore, in order 

to better anchor inflation expectations, the CBK embarked on reforms geared towards 

transforming its framework from the quantity-based monetary aggregate targeting 

framework to a forward-looking monetary policy framework. 

However, the adoption of this new monetary policy framework slowed down with the 

introduction of interest rate caps between September 2016 and November 2019, and 

the disruptions caused by the placement of three commercial banks under receivership 

in 2015 and 2016, a move that undermined the effectiveness of monetary policy 

transmission. The repeal of interest rate caps served to restore the clarity of monetary 



13 

 

policy decisions and was expected to strengthen the transmission of monetary policy 

(MPC, 2021). 

Other teething troubles associated with the transition to the forward-looking monetary 

policy framework were the misalignment of the policy rate and short-term rate due to 

inefficiencies in the interbank market, largely attributed to segmentation, and the lack 

of transparency in commercial bank loan pricing. These will need to be addressed by 

the CBK and the findings of this study could help to inform the practical solutions. 

According to Ochieng et al. (2016), the inflation targets in Kenya have been frequently 

missed and the implication of such dynamic inconsistencies is that macroeconomic 

policies formulated on the basis of inconsistent inflation forecasts may have a negative 

impact on economic growth. They further state that many reasons have been advanced 

for dynamic inconsistencies among them deficient models. These deficiencies include 

the lag selection, inappropriate transmission mechanism, inefficiency of financial 

systems and poor choice of policy tools. 

Interestingly, Misati et al. (2012) studied the feasibility of inflation-targeting in an 

emerging market and concluded from the results that the Kenyan economy does not 

meet all the conditions necessary for adopting inflation-targeting. This is critical since 

inflation-targeting as a policy objective has been in place for over twenty-five years. 

1.3. Problem Statement 

The CBK is mandated to formulate and implement monetary policy directed towards 

achieving and maintaining stability in the general level of prices (low and stable 

inflation). With price stability also as the most common monetary policy objective 

globally, its importance cannot be ignored. 

As observed from historical KNBS data, the inflation rate in Kenya has been volatile, 

reaching as high as 15.96 percent in March 2009 and as low as 3.18 percent in October 

2010.  

We have already established that in the balance of things, an elevated level of inflation 

is undesirable by economic agents because it causes a depreciation of the local 

currency relative to international currencies. Depreciation of a currency tends to 

increase a country’s balance of trade (net exports) by improving the competitiveness 

of domestic goods in foreign markets while making foreign goods less competitive in 

the domestic market by becoming more expensive. 



14 

 

A high inflation environment also makes it difficult for long-term financial planning 

with regard to investments and savings, resulting in an inefficiency in a market 

economy and, subsequently, a lower rate of economic growth. In an ideal economy, 

price stability would be present, and the wider economic goal of strong and sustainable 

growth and employment would be achieved. 

Price stability is a major challenge for developing countries. In the case of Kenya, this 

had been an elusive target for the CBK, though it has improved in recent years. As 

noted by Ochieng et al. (2016), inflation targets in Kenya have been missed frequently, 

and the level of inflation has been higher compared with the level of inflation in 

developed and emerging economies. Such missed inflation targets present a dynamic 

inconsistency challenge to policy makers.  

Furthermore, given the weight taken by food and non-alcoholic beverages in the 

consumption basket used to compute Kenya’s CPI, high inflation will be reflected in 

food prices. As stated in the Kenya Economic Report 2020 (KIPPRA, 2020), since 

food CPI and overall CPI move together, persistent food inflation can be a threat to 

macroeconomic stability. Whereas the affluent can easily forego certain luxuries and 

bootstrap, high food prices would end up having more adverse effects on the poor who 

have less disposable income.  

The effects of inflation on development cannot be emphasised enough. The poor spend 

a larger share of their incomes on food, and therefore high food inflation is likely to 

affect them more than other segments of the population. High food prices also have 

the potential to push some middle-income households back to below poverty lines. 

Inflation is also sensitive to economic and political events. Kenya has observed 

economic crises such as the foreign exchange rate crises of 1993, 1997 and 2015. The 

collapse of commercial banks such as Charterhouse Bank (under statutory 

management), Chase Bank (acquired by a foreign entrant), Imperial Bank and Dubai 

Bank (both insolvent) have served to erode investor confidence. These have a direct 

impact on inflation as well given the contagion effects. The recent global financial 

crisis and the COVID-19 pandemic have also impacted inflation in Kenya. 

Politically, the onset of multi-party politics and the general election cycles have had 

an impact on inflation. The post-election violence of 2007 had a longstanding effect 

on the perception of Kenya’s political risk given that the country had been known as 

the model of peace within the East African region. The violence that ensued after the 

general election had a notable impact on the economy well into 2008.  



15 

 

Given the unique characteristics of developing countries, it is quite interesting to note 

from literature that there is no consensus on the global determinants of inflation 

(Frankel, 2010; Modena, 2008). Scholars such as Ochieng, Mukras and Momanyi 

(2016), Odusanya and Atanda (2010), KebretTaye (2013) and Gyebi and Boafo (2013) 

idenfity differing determinants of inflation. 

By gaining an understanding of the determinants of inflation in Kenya, it is envisaged 

that by adjusting these factors, policy makers would be better placed to develop 

appropriate policies to ensure that inflation is managed well enough to achieve price 

stability. The end goal of this is to achieve sustained economic growth. 

1.4. Research Objectives 

The main objective of the study was to evaluate the determinants of inflation in Kenya 

and the moderating effects of governance regimes. 

The specific objectives of this study were to: 

i. Evaluate the monetary determinants of inflation in Kenya (those that relate to 

monetary policy transmission). 

ii. Evaluate the non-monetary determinants of inflation in Kenya. 

iii. Appraise the moderating effect of the governance regime (with respect to the 

President and Central Bank Governor) in place on inflation in Kenya. 

1.5. Research Questions 

i. To what extent do monetary determinants influence inflation in Kenya? 

ii. To what extent do non-monetary determinants influence inflation in Kenya? 

iii. How much does the governance regime in place (with respect to the President 

and Central Bank Governor) moderate the rate of inflation in Kenya? 

1.6. Scope of Study 

This study examined quarterly data for the period from 1996 to 2020. This was a period 

characterised by the monetary policy objective of inflation-targeting after the shift in 

1993 from a fixed exchange rate policy environment to a floating rate environment. It 

can be inferred that with an allowance of about three years, the transition had become 

fully adopted by 1996. 



16 

 

The study relied on secondary data that is publicly available for the period. Unlike the 

study by Mehl (2006), the focus of the study was on one country only – Kenya – and 

it did not consider exchange rate impact brought about by trade and diaspora 

remittances. 

Fiscal policy tools such as taxes and subsidies were not covered in this study as part 

of non-monetary factors. This is because taxes and subsidies tend to be subjective 

depending on the dynamics of the country in question. 

Nascent issues in finance such as cryptocurrencies were not considered in this study, 

though they are likely to become significant once more data becomes available in the 

future. 

The global coronavirus (COVID-19) pandemic has also had far-reaching effects. In 

recent times, this phenomenon has impacted economies globally with an observed rise 

in inflation rates. Central bankers had gone to great lengths to manage inflation given 

the lockdowns of the global economy. This study however did not consider much of 

the period as it occurred at the tail-end of the period under study.  

Therefore, this study did not delve deeper into external shocks as such as the global 

financial crisis and more recently, the global COVID-19 pandemic that create 

uncertainties for economic agents (MPC, 2021). These would necessitate event studies 

of their impact on inflation as more information becomes available. 

1.7. Significance of the Study 

Ultimately, the objective of this study was to shed more light on the issue of inflation 

in developing countries. Since such countries aim to eradicate poverty and achieve 

economic growth, it was worth considering. It is therefore important for such countries 

to achieve a low and steady rate of inflation to spur sustainable economic growth in 

the long run.  

There is need to establish a working framework for economic agents to be able to make 

proper daily economic decisions to enable them to achieve sustained economic growth 

and development. 

1.7.1. Households 

Households would benefit from the knowledge of determinants of inflation to inform 

their decision-making aimed at maximising utility, their main economic objective. A 

high inflation has a direct impact on the purchasing power of households with 



17 

 

implications on their basket of goods and services. This manifests through adjustments 

to their disposable income by saving, adjustments to their budgets and foregoing 

certain luxuries in times of strife. Furthermore, inflation impacts long-term 

investments of households such as pension savings. 

1.7.2. Firms 

Firms would be keen concerning expenditures as well, more importantly with regard 

to wage-setting, borrowing and investing. For firms as borrowers, a high inflation 

environment is ideal as it reduces the effective cost of debt in the long run. On the 

contrary, the high inflation environment could adversely impact the firms as lenders 

in the long run. Firms also consider inflation when evaluating investments to ensure 

that the return on investment is more than the rate of inflation. 

1.7.3. The government 

The government would primarily be concerned with achieving economic growth in a 

manner that minimises dissent due to high inflation, especially in the run up to an 

election for a second term.  

Inflation could potentially lead to massive demonstrations and revolutions. For 

instance, inflation and especially food inflation is widely considered to be one of the 

main reasons that caused the French Revolution, the 2010–11 Tunisian revolution and 

the 2011 Egyptian revolution. Tunisian president Zine El Abidine Ben Ali was ousted. 

Egyptian President Hosni Mubarak was also ousted after only 18 days of 

demonstrations. The protests soon spread in many countries of North Africa and 

Middle East in what has come to be known as the Arab Spring. Notably, the high food 

inflation contributed to the French Revolution that was premised on social and 

economic inequality. 

The study has a host of other potential beneficiaries within the government, key among 

them, the treasury and the central bank, which act as the market maker, and borrower 

respectively. The central bank would be interested in informing monetary policy 

transmission as it strives to further enhance its inflation-targeting monetary policy 

framework. The CBK is in the process of modernizing its monetary policy framework 

and operations (MPC, 2021). 

Other government agencies would also be able to glean useful information from this 

study. Regulatory bodies of the financial markets would be interested to identify 

policies that could be developed to enhance the vibrancy of the financial markets. 

These include the Capital Markets Authority (CMA), the Sacco Societies Regulatory 



18 

 

Authority (SASRA), the Retirement Benefits Authority (RBA) and the Insurance 

Regulatory Authority (IRA). This is because a number of financial instruments in the 

Kenyan market have a keen interest in inflation such as pension funds, savings 

accounts and unit trusts. The CBK is also a regulator of banks which also offer such 

products. The Kenya Revenue Authority as the revenue collection agency of the 

government would be interested to note if certain inefficiencies could be addressed. 

1.7.4. Investors 

Market participants as investors would be keen to know whether there is any 

inefficiency that could be exploited to make a return. There is need to identify the 

determinants of inflation in order to tweak them to a desired effect. This is crucial 

given their signalling effects to both the citizens and the international markets, 

particularly with regard to factors such as unemployment and cost of living. 

Foreign investors would also follow the inflation statistics keenly to identify 

opportunities for investment. A high level of inflation would be cause for concern, 

particularly for foreign direct investment. 

1.7.5. Academia and Policy Makers 

Policy makers would be keen to monitor the movements in the economic indicators to 

adjust policy and balance with the concerns of the political class. There is need to 

appreciate the implications of inflation on the bottom of the pyramid, particularly with 

regard to food prices. A high inflation environment could potentially also bring 

middle-income households to below the poverty line. 

Academia would be keen on this study since there is already a shortage of research on 

financial markets in developing countries. Most research globally has drawn 

conclusions from developed countries whose conditions may differ drastically from 

those in emerging economies. 

  



19 

 

CHAPTER 2: LITERATURE REVIEW 

2.1. Introduction 

In this chapter, the theoretical literature is put forth to explain the phenomenon of 

inflation as well as the empirical literature. 

The rest of this chapter will cover a theoretical review of the literature followed by an 

empirical review. A critique of the same will follow thereafter and subsequently, the 

conceptual framework of the study will be laid out. 

2.2. Theoretical Review 

The study of inflation has been extensive over the years and three broad approaches 

have been developed over time. Firstly, the monetary approach views inflation from 

the perspective of it resulting from a distinct relationship between money and prices. 

This approach considers the point of view that monetary determinants of inflation are 

the key factors, considering that money is itself an asset.  

The second approach is the public finance approach which looks at inflation as the 

result of a monetary expansion occurring in response to fiscal imbalances. A fiscal 

imbalance arises whenever a government fails to meet its revenue targets to fund its 

expenditures, resulting in a budget deficit.  

Fiscal imbalances in developing countries with scarce resources often lead to 

monetisation of the fiscal deficit. Whereas the fiscal environments of developed 

countries tend to be similar, such dynamics tend to differ for emerging markets. This 

may be due to differences in political philosophies (such as Kenya and Ethiopia as 

identified by Durevall and Sjö (2012)); endowment of natural and economic resources; 

and external motivations for certain fiscal policies (such as dependence of foreign aid 

that could tether countries to demands of donors and supranational organisations). 

Since fiscal policy may vary from country to country, this was not considered for this 

study. 

The third approach put forth is whereby scholars look at the structural and cost-push 

explanations of inflation. They posit that inflation arises due to oligopolistic behaviour 

by firms. Essentially, they argue that inflation is the result of producers apply a mark-

up when pricing as well as cost pressures stemming from wage increases and 

devaluations. 



20 

 

Other than the aforementioned, there is another frequently-cited category of sources 

of inflation that is characteristic primarily of developing countries – inertia. As for 

inertia, inflation may also arise from the sluggish adjustment of expectations. This is 

because most prices and wages are normally set with future economic conditions in 

mind, especially with regard to firms. As such, economic agents tend to refer to recent 

inflation rates to forecast the inflation rates of the near future. 

The theoretical review of this study delves deeper into understanding inflation by 

considering three broad categories of perspectives: the monetarist perspective, the non-

monetary perspective (excluding fiscal policy) and the heterodox views on inflation. 

The heterodox or unorthodox views are examined with a view to understanding their 

assumptions and bases for their rejection. 

2.2.1. Monetary Perspective 

When observed from a monetary lens, inflation is fundamentally premised on the law 

of demand and supply given its relation to prices. From a macroeconomic standpoint, 

the root of inflation is money given that the concept of prices relates directly to money. 

Price however is a manifestation of consensus on value of a good or service. The 

distinction between price and value is fodder for philosophical debate. This is the cause 

of variance in prices within markets in an economy, leading to a contradiction of the 

Law of One Price. Some economists could argue that this is essentially the lifeline of 

an economy – the variation in prices creates markets. 

From this perspective, there are two major considerations: demand-pull factors and 

cost-push factors. Demand-pull inflation arises notably from shocks in aggregate 

demand within an economy. Samuelson and Nordhaus (2010) define demand-pull 

inflation as that which arises when aggregate demand rises more rapidly than the 

economy’s productive potential, pulling prices up to equilibrate aggregate supply and 

demand. Such demand-pull factors relate to changes in government spending, 

investment and net exports. An instance when this may manifest through deficit 

spending such as when a government prints money. 

Cost-push or supply-shock inflation relates to the aggregate supply curve. It arises 

because of an increase in the cost of inputs and leads to stagflation (a period of 

stagnation with inflation).  

The classical theory of inflation defines money as an asset that is regularly utilized by 

people to purchase goods and services. Akinboade, Siebrits and Niedermeier (2004) 

suggest that the simplest approach to price determination in an open economy is that 



21 

 

of purchasing power parity (PPP) whereby absolute purchasing power parity implies 

that price levels in different countries move towards equality in common currency 

terms. This emanates from the Law of One Price, which states that any commodity in 

a unified market has a single price. This speaks to the exchange rate as a form of 

relative price in an economy. 

Akinboade et al. (2004) identify the shortcomings of the absolute purchasing power 

parity theory and suggest a less restrictive theory: the relative purchasing power parity 

theory. This theory implies that even when there are trade barriers, as long as these 

barriers are stable over time, the percentage change in the nominal spot exchange rate 

between two currencies should equal the inflation differential between the respective 

countries. 

In the same vein, the Fisher effect is an important consideration as it addresses inflation 

in relation to both real and nominal interest rates. One of the foremost explanations of 

inflation emanated from the Fisher effect which was developed by Irving Fisher. It has 

been extended to the analysis of the money supply and international currencies trading. 

The Fisher Effect states that the real interest rate equals the nominal interest rate minus 

the expected inflation rate. 

Among the most common theories that have been put forth to explain inflation is the 

monetarist theory. This theory was proposed by Cagan (1956) who viewed inflation as 

being caused by monetary growth and focused on the demand for money during 

hyperinflation. He held the view that past inflation rates influenced the expectations of 

future inflation rates. 

Friedman (1982) emphasised the monetarist theory by revisiting the quantity theory of 

money. This theory examined the fundamentals of money within an economy. From 

his assessment, the price level within the economy was determined by the velocity of 

money (how fast money circulates within the economy) and the total number of 

transactions in the economy. 

He presented this in an equation whereby the product of total money within an 

economy and the velocity of money is equal to the product of price level and total 

number of transactions within and economy. The number of transactions is often used 

interchangeably with the level of output. Transactions and output are related, because 

the more the economy produces, the more goods are bought and sold (Mankiw, 2010).   

Therefore, on this basis, the price level in an economy is a factor of money supply, 

velocity and output. It was widely held that velocity and output are exogenous factors 



22 

 

in the classical quantity theory of money, thus implying that the price level is a factor 

of money supply. This was stated as Fisher’s equation of exchange which views money 

as a medium of exchange (transactions version). 

Economists from Cambridge University 4  developed the Cambridge cash balance 

equation which considered money as a store of value instead. In their version, the 

demand for money within an economy was a result of the interplay of the price level 

within an economy, the level of output and the portion of money held for convenience 

and security of having cash at hand. 

Most economists concur that the quantity theory holds true in the long run. However, 

there is still disagreement about its practicality in the short run. Critics have expressed 

their aversion to the assumption that velocity is stable. Similarly, they argue that in the 

short-run, prices are sticky, so that there is no direct relationship between money 

supply and price level. An example is wages which could be reviewed after several 

years. 

Keynes (1936), himself a Cambridge economist, developed a model to explain the 

nature of money within an economy by considering liquidity preference. Keynesian 

liquidity preference theory distinguishes three distinct motives for holding money:  a 

transaction motive, a speculative motive and a precautionary motive. These speak to 

the need for keeping money for purchase of goods and services, taking advantage of 

arbitrage opportunities, and hedging or holding it for a rainy day respectively. 

With regard to inflation, the speculative demand is the most influential since it 

considers the interest rate movement in the bond markets. The speculation arises when 

one believes that they can take advantage of interest rate movements in the financial 

markets. This speaks to the inverse relationship between bond prices and interest rates. 

If interest rates are high, the demand for bonds increases relative to the demand for 

money. If interest rates are low, there is little incentive to hold bonds – investors would 

rather maintain liquidity by placing funds in cash and cash equivalents. It is important 

to note that the demand for money is negatively correlated with interest rates and 

positively correlated with real income. 

Friedman (1956), who was widely viewed as a proponent of free-market thinking, 

improved on the Keynesian liquidity preference model by treating money like any 

other asset. He achieved this by integrating an asset theory and a transactions theory 

 
4 Cambridge economists include A. C. Pigou, Alfred Marshall and John Maynard Keynes (before he 

developed his own theory). 



23 

 

of the demand for money within the context of neoclassical microeconomic theory of 

consumer and producer behaviour. This allowed him to incorporate arguments for 

utility and production functions. He further opined that the marginal utility of money 

declines as the quantity of money held increases. A major assumption was that money 

competes with other assets such as bonds, stocks and physical goods for placement 

within the portfolios of economic agents. 

He therefore concluded that economic agents would be keen to hold real assets as 

opposed to nominal assets. The same applies to money. From the standpoint that 

inflation erodes the purchasing power, economic agents would then prefer to hold 

higher nominal amounts of money to compensate for the eroded real value. According 

to Friedman’s argument, the level of real balances is a function of the relative expected 

return on assets such as stocks and bonds in comparison to money and expected 

inflation. 

More recently, Mundell (1963) and Tobin (1965) proposed what has come to be known 

as the Mundell-Tobin effect, which is an explanation of the impact of inflation on 

economic growth premised on neoclassical growth theory. They posit that an increase 

in the nominal interest rate caused by inflation, makes investment more preferable than 

consumption, which in turn, causes an increase in the accumulation of capital, thus 

leading to economic growth. 

2.2.2. Non-monetary Perspective 

In general, the cause of inflation in developed countries is broadly identified as growth 

of money supply whereas in developing countries, inflation is not a purely monetary 

phenomenon (Totonchi, 2011). The literature on non-monetary determinants of 

inflation is centred on structuralist as well as cost-push factors.  

Cost-push inflation arises from a shock to the aggregate supply within an economy. 

Examples of these include natural disasters or increased prices of inputs such as oil. 

The focus of cost-push inflation is on producers who may pass on costs to the 

consumers through increased prices. Under the cost-push theory, inflation is seen as 

the result of factor prices accelerating more rapidly than factor productivities 

(Ochieng, Mukras and Momanyi, 2016). 

Gil-Alana and Mudida (2016) identify supply-side shocks in the Kenyan economy 

such as droughts or oil price hikes which are not directly under the control of the 

monetary authorities. Such factors directly impact the cost of production, particularly 

with regard to energy and transport costs. The costs are then passed on to the consumer 



24 

 

by the producers. Other examples are conflict and changes in the terms of trade which 

can lead to persistent changes in the price level. 

High inflation can lead to employees demanding rapid wage increases to keep up with 

consumer prices. In the case of collective bargaining, wage growth would be set as a 

function of inflationary expectations, which tend to be higher when inflation is high. 

In essence, inflation begets further inflationary expectations, which beget further 

inflation in a form of wage spiral. 

Totonchi (2011) identifies profit-push inflation as cause of cost-push inflation 

whereby monopolist and oligopolist firms take advantage of imperfect competition to 

raise the price of their products with a view to offsetting the increased labour costs and 

cost of production so as to increase their profits. 

Non-monetary factors have been evaluated empirically. Phillips in 1958 plotted the 

rate of inflation in the United Kingdom against the rate of unemployment and the result 

was a negative correlation (Blanchard, 2017). Paul Samuelson and Robert Solow later 

replicated the same exercise in 1960 for the US using the CPI as their measure of 

inflation. This relation was henceforth labelled the Phillips curve. Most of the existing 

literature on inflation has been premised on this perspective. 

Structural factors also have a role to play. The structuralist theory states that inflation 

arises because of structural rigidities in the economy. Examples of structural rigidities 

or imbalances include the imbalance between demand and supply of industrial inputs 

whereby governments are then forced to depend on deficit financing as commonly 

observed in emerging economies. This arises because of insufficient external 

borrowing, grants and aid. 

Other structural imbalances that lead to inflation include foreign exchange bottlenecks 

and infrastructure bottlenecks, food insecurity, social and political constraints. 

Fundamentally, structuralist economists argue that inflation is the culmination of 

structural rigidities in the economy. 

The structuralist model of imported inflation proposed by Frisch (1977) shows that a 

country’s dependence on external markets may bring about inflation, since heavy 

reliance on external variables is expected to motivate upward pressure on domestic 

prices. This is likely to impact developing countries with a heavy reliance on imports. 

Another model from the structuralist school of thought, the Scandinavian model Frisch 

(1977), which seems mostly relevant to small open economies hypothesizes that 



25 

 

inflation is influenced by world prices, wages and productivity. Other factors include 

adverse weather conditions and trade protection policies that may impact inflation. 

Inflation could also be understood to be a consequence of the behaviour of economic 

agents. The rational expectations theory builds on the learning curve of economic 

agents. Taking the example of the labour market that may find itself in a wage spiral, 

economic agents tend to form adaptive expectations. As prices and wages continue to 

rise, economic agents act rationally as they plan for this by observing the most recent 

patterns. They expect current inflation rates to continue into the future and therefore 

demand more wages to maintain their standard of living resulting in built-in inflation. 

The interaction among economic agents influences inflation and given that central 

banks are not fully in control of all factors, necessitates the adoption of policies to 

attempt to achieve the target level of inflation. As identified by Lo (2004), specific 

behavioural biases 5  that manifest when human decision-making occurs under 

uncertainty may lead to undesirable outcomes for the economic welfare of an 

individual. 

This is aligned to the adaptive market hypothesis proposed by Lo (2004) which was 

an improvement from the efficient market hypothesis by Fama (1970)6. The theory by 

Lo (2004) simply states that economic agents adapt to their ecosystem (the economy) 

over time given the information accessed as well as historical patterns observed. The 

most recent information tends to have the most impact; in this case, the most recent 

level of inflation influences expected inflation. 

The interplay of the behavioural biases of economic agents could also cause inflation 

inertia. Durevall and Ndung'u (2001) address inflation inertia which they say is usually 

interpreted as measuring the effects of indexation or inflation expectations. They go 

on further to say that when there is no inertia7, the parameters on lagged inflation 

should be zero. They add that in the other extreme, when the level of inflation is only 

determined by inertia, the parameters on lagged inflation should sum to unity. This 

study looked into inertia to test its influence on inflation over the period by examining 

its lagging effects. 

 
5 Examples include over-confidence, herding, loss aversion, overreaction, miscalibration of 

probabilities, psychological accounting, hyperbolic discounting and regret. 

6 The efficient market hypothesis states that prices reflect all available information. The adaptive 

market hypothesis builds on this by applying Darwinian principles. 
7 as claimed by Killick and Mwega (1989) and Mwega (1990), and implied by the model of Ryan and 

Milne (1994) 



26 

 

2.2.3. Hybrid Models 

Akinboade et al. (2004) identify the emergence of hybrid (structuralist-monetarist) 

models of the determinants of inflation, stating that fundamental structural and cost-

push factors had been omitted from the monetarist models. They note that this 

omission has been rectified in recent literature with several authors having developed 

models by directly augmenting the monetarist approach with cost-push factors. 

Totonchi (2011) identifies the New Neoclassical Synthesis (NNS), as popularised by 

Samuelson, who billed it as an engine of analysis which offered a Keynesian view of 

determination of national income and Neoclassical principle to guide macroeconomic 

analysis. He goes on to add that in the NNS, monetary (or demand) factors are a key 

determinant of business cycles because of the incorporated new Keynesian assumption 

of price stickiness in the short run, while at the same time, however, the NNS assigns 

a potentially large function to supply shocks in explaining real economic activity, as 

suggested in the new classical real business cycle theory. 

2.2.4. Heterodox views 

There are a number of points of view on inflation that are not widely accepted by 

mainstream economists. These are quite simply unorthodox to neoclassical economics 

that stem from a difference of perspective and ideologies. The quantity theory has 

previously been contrasted by a number of economists with a number of other theories 

and withstood the test. These include the Austrian view, the real bills doctrine, the 

backing theory and the Marxist theory. 

The Austrian view is premised on the argument that inflation does not manifest in a 

uniform manner across the economy (pure inflation). According to Shostak (2000), the 

Austrian school of thought stress that inflation affects prices in various degrees – prices 

rise more sharply in some sectors than in other sectors of the economy. This 

contravenes the argument of aggregate price levels with regard to inflation. 

Naturally, this theory fails on the basis that it would be difficult to identify the rate of 

inflation with consideration for all the unique circumstances of economies and not 

allow for comparability among economies. 

The Real Bills doctrine brings forth the argument of fractional reserve accounting, 

generally gold, in relation to money supply. This view put forth is that banks should 

also be able to issue currency against bills of trading, which is “real bills that they buy 

from merchants”. According to Timberlake (2005), the debate between currency, or 

quantity theory, and banking schools in Britain during the 19th century foreshadowed 



27 

 

the present-day debate on the credibility of money, given the move toward novel 

cashless forms of money such as blockchain technology and mobile money. 

However, it is important to note that this doctrine was developed in the 19th century 

when the banking school had greater influence on policy in the United States and Great 

Britain, while the currency school was more dominant in non-British countries, 

particularly in the Latin Monetary Union and the earlier Scandinavia monetary union. 

This doctrine failed, according to Rothbard (2008), following the collapse of the 

international gold standard post 1913, and the move towards deficit financing of 

government. 

The backing theory (also known as the anti-classical theory) posits that the assets and 

liabilities of the issuing agency determine the value of money. In contrast to the 

quantity theory, the anti-classical theory argues that authorities can issue money 

without significant impact on inflation so long as they have adequate assets to cover 

redemptions. Baumol and Alan (2006) state that there are very few proponents of this 

theory, making quantity theory the dominant theory explaining inflation.  

Another theory that is rather unpopular in the explanation of inflation is the Marxist 

theory. The longstanding debate of Marxist philosophy has found its way to economic 

debate, and it is small wonder that its socio-political underpinnings have created 

divisions on economic thought, notwithstanding the varied interpretations of Marxist 

philosophy. The Marxist philosophy applied to economics is characterised by the 

relationship between those that provide the labour required to produce the goods (the 

proletariat) and those that buy the goods (the bourgeoisie) in the determination of 

value. 

According to Bresciani (2006), the Marxist theory states that it is the value of the 

labour required to produce the goods and not the price of the goods themselves that 

determines the real cost of the goods and that the only important factor in the cost of 

goods is how the cost of labour goes up and down compared to the demand for the 

product by those with money – the bourgeoisie. Marx defined inflation in terms of its 

cause as depreciation of the currency arising from printing notes in excess of the basic 

quantity of gold. 

  



28 

 

2.3. Empirical Review 

This study has a focus on inflation in developing countries. An examination of 

empirical literature available gives varied conclusions as to the determinants of 

inflation. This section begins with a coverage of literature on inflation in emerging 

economies followed by sub-Saharan Africa. Lastly, literature on the Kenyan context 

is examined. 

2.3.1. Monetary Factors and Inflation 

With regard to monetarist theory, there has been focus on the term structure of interest 

rates and its relation to inflation, particularly with regard to expectations. This has 

received considerable support. 

On studying the yield curve characteristics in emerging economies. Mehl (2006) noted 

that the domestic yield curve in emerging economies has in-sample information 

content even after controlling for inflation and growth persistence, at both short and 

long forecast horizons, and that it often improves out-of-sample forecasting 

performance. He also noted differences across countries are seemingly linked to 

market liquidity. 

Ang, Bekaert and Wei (2007) studied the term structure of real interest rates in relation 

to inflation and concluded that changes in nominal interest rates must be due to either 

movements in real interest rates, expected inflation, or the inflation risk premium. An 

interesting finding was that the real short rate was negatively correlated with both 

expected and unexpected inflation, but the statistical evidence for a Mundell-Tobin 

effect was weak. 

The paper by Mishkin (1990) provides empirical evidence on the information in the 

term structure for longer maturities about both future inflation and the term structure 

of real interest rates. He further adds that when the slope of the term structure steepens, 

it is an indication that the inflation rate will rise in the future. 

The findings of Mishkin (1990) and Ang, Bekaert and Wei (2007) are aligned to the 

famous assertion by Friedman (1960) that “inflation is always and everywhere a 

monetary phenomenon. 

Modena (2008) used a threshold model to examine the term structure of interest rates 

in relation to the expectations hypothesis. The hypothesis implies that rational 

investors can predict future changes in interest rates by simply observing the yield 

spread. On empirically examining the determinants of inflation, an interesting 



29 

 

observation is that there has been no consensus on factors in developing countries. As 

stated by Totonchi (2011), inflation in developed countries is deemed to be broadly 

caused by growth of money supply whereas in developing countries, inflation is not a 

purely monetary phenomenon. 

Similar studies were carried out by Lim and Papi (1997) in Turkey as well as Lim and 

Sek (2015) in Malaysia. In the case of Turkey, it was observed that monetary variables 

(initially money, more recently the exchange rate) play a central role in the inflationary 

process, that public sector deficits contribute to inflationary pressures, and that inertial 

factors are quantitatively important. Moreover, the commitment by policymakers to 

active exchange rate depreciation on several occasions in the prior 15 years also 

contributed to the inflationary process. 

As for the Malaysian economy, GDP growth and imports of goods and services were 

found to have a significant long run impact on inflation in low inflation countries. The 

findings also indicated that money supply, national expenditure and GDP growth are 

the determinants of inflation which impose long run impact on inflation in high 

inflation countries. In the short run likewise, none of the variables was found to be 

significant determinants in high inflation countries. However, money supply, imports 

of goods and services and GDP growth has significant relationship with inflation in 

low inflation countries. 

Among the specific country studies carried out on the determinants of inflation were 

Botswana (KebretTaye, 2013), Ghana (Gyebi and Boafo, 2013), Tanzania (Ndanshau, 

2010) and Nigeria (Odusanya and Atanda, 2010; Dahiru and Sulong, 2017). 

 For Botswana, price inertia, real GDP, money supply and South African prices were 

observed to play a dominant role in determining inflation. Similarly, a conclusion of 

the study was that unless international deflationary environment prevails, it was highly 

unlikely that the Bank of Botswana would achieve its medium-term objective range of 

3 to 6 percent in the medium-term. 

As for Ghana, Gyebi and Boafo (2013) focused on the period between 1990 and 2009 

and observed that real output and money supply are the strongest forces exerting 

pressure on the price level to move up the exchange rate depreciation. Additionally, 

they found that the implementation of the Economic Recovery Program (ERP) helped 

reduce the level of inflation in Ghana giving evidence that the ERP achieved its basic 

objective of reducing inflationary trend in Ghana.  



30 

 

In a study of the Nigerian context by Odusanya and Atanda (2010), the inflation rate, 

growth rate of real output and money supply, and real share of fiscal deficit were found 

to be stationary, while other incorporated variables in the empirical analysis (real share 

of import, exchange rate and interest rate) were found to be stationary at first 

difference. 

An ARDL approach was also applied by Ndanshau (2010) in their study of Tanzania 

and it was concluded that factors, particularly growth in real income, were found to 

exert the expected depressive influence on inflation; a finding that underscored the 

importance of the demand for money in explaining inflation. Ndanshau (2010) also 

found other important structural factors influencing inflation in Tanzania – nominal 

exchange rate and inflation inertia. He found that on aggregate the long run influence 

of changes in money was found to be very small if compared to that exerted by 

structural factors. 

An assessment by Melaku (2020) of empirical studies conducted in the past on the 

determinants of inflation in Africa concluded that output/national income, broad 

money supply, price of imported goods and services and exchange rate are the critical 

variables affecting the performance of inflation. Other variables (interest rate, price 

expectation and population growth) were also found to be slightly important. 

Further to these, it was observed that almost all literature examined used macro 

variables without consideration for factors such as political and social institutions. A 

recommendation from the study was that countries should seriously work on creating 

moderate inflation to grow their economy by increasing their national income in 

addition to stable fiscal and monetary policy with a focus on the aforementioned 

factors. 

Mwega (2014) studied the term structure of interest rates in Kenya in an attempt to 

link it to inflationary expectations and concluded that the slope of the term structure is 

a good predictor of expected inflation. However, the study had the limitation of a 

relatively short period over which the analysis was done (TBR182 minus TBR91) and 

that the analysis for 364-day Treasury bill versus the 91-day Treasury bill gave non-

significant results with only 10 observations involved. 

Kiganda and Omondi (2020) studied the influence of monetary factors on inflation in 

Kenya. They examined monthly time series data from CBK spanning from 2005 to 

2018 and the results indicated that total money supply had a positive influence on 

inflation that was highly influenced by extended broad money. The study concluded 



31 

 

that imports influence inflation in Kenya, but commercial imports highly determined 

total imports influence on inflation in Kenya. 

However, Ochieng, Mukras and Momanyi (2016) studied the determinants of inflation 

and found that price fluctuations and lag inflation rates greatly affect inflation rate 

positively while real GDP growth affects inflation rate negatively. The findings also 

showed that money supply growth, foreign exchange rate and interest rate do not have 

a significant relationship with inflation.  

In addition, they tested whether inflation could be explained by a non-linear model. 

The findings revealed that the inflation model exhibits a linear structure as the 

coefficients of squared terms of the predictor variables were found to be statistically 

insignificant. Based on the aforementioned findings, the study concluded that real 

GDP growth is the main instrument policy makers should aim at in controlling the 

inflation rate.  

2.3.2. Non-Monetary Factors and Inflation 

A number of the empirical studies on determinants of inflation posit that non-monetary 

factors tend to complement monetary factors, thus providing support for the NNS 

theory. 

Dahiru and Sulong (2017) studied the long-run relationships of specific determinants 

of inflation in Nigeria as well with an ARDL approach. They concluded that there was 

indeed a long-run relationship, a positive one with the exchange rate, broad money 

supply, oil price and inflation; and a negative one with financial instability, interest 

rate, gross domestic product and broad money supply nominal effective. They 

recommended that the monetary authority in Nigeria pursue price stability either 

through monetary policy or the exchange rate target since shocks in both money supply 

and exchange rate influenced the rate of inflation. 

Gil-Alana and Mudida (2016) econometrically examined the CPI and the inflation rate 

in Kenya, using quarterly data, for the time period 1963Q1 to 2013Q4. The results 

indicated both series (CPI and inflation) display high degrees of persistence, with 

orders of integration equal to or higher than 1 for CPI and smaller than 1 though 

positive, and thus showing long memory and mean reversion in the inflation rate. The 

implication drawn from this was the need for strong policy action to deal with inflation 

shocks in Kenya. 

They noted that Kenya’s current monetary policy is already based on inflation-

targeting within the framework of Taylor’s Rule, the policy implication being that 



32 

 

significant increases in inflation (falling outside medium-term central bank targets) 

should be addressed decisively and swiftly by raising the Central Bank Rate 

sufficiently despite the negative short-term consequences on economic growth. 

Interest rates can then be eased once inflationary pressure subsides.  

They however noted a challenge for monetary policy in Kenya of inflation – supply-

side shocks such as droughts or oil price hikes which are not directly under the contr