Relationship between Inflation and Money Supply in Kenya

Inflation is an inevitable property of any economy in the world. Inflation has been a topical issue since the early 1970s when oil prices soared to record high figures. Ever since, controlling the inflation rate has been a high priority of many countries especially those with small open economies. There was resurgence of high inflation; with average rates being 3.6% for advanced economies, 7.3% for emerging Asia and 10.2% for Africa in 2008. Inflation in Kenya became high - fluctuating between 10 and 20 percent annually from the 1970s to the mid-1980s, and accelerated further to 47.7 percent in 1993. East Africa witnessed in October of 2011 a considerable surge in inflation reaching on average 20%. Kenya in the same year and month recorded an inflation rate of 18.9%. The failure by Central Bank of Kenya (CBK) to achieve the 5% inflation target in Kenya and lack of consensus on the causes of rise in inflation made it necessary to find out some of the determinants of inflation. The purpose of this study was therefore was to establish relationship between inflation and money supply in Kenya. The study specifically sought to determine the relationship between money supply and inflation and analyze the validity of the Monetarist theory in Kenya. This study was modeled on the Monetarist theory and based on correlation research design with target population consisting macroeconomic variable of money supply that is hypothesized to affect inflation in Kenya. The sample consisted of annual time series data spanning 29 years from 1984 – 2012. Data was obtained from the World Development Indicators. The study used Vector Error Correction Mechanism to integrate long run and short run dynamics and Granger causality for directional causality. The results indicated significant positive long run relationship between inflation and money supply in Kenya and inflation is significantly error correcting at 68% annually. Unidirectional causality was also established running from money supply to inflation validating Monetarist theory. We concluded that in the long run money supply is a significant determinant of inflation in Kenya. In view of this, the study adds to literature by proving Monetarist theory and recommends that the government of Kenya to continue pursuing tight monetary policy anchored on broad money to control inflation.