Monetary-fiscal policy interdependence and pricing dynamics: Empirical estimation of fiscal dominance in Kenya

The aim of this study was to examine the effectiveness of monetary and fiscal policies with a view to establishing the existence of fiscal dominance in Kenya. The study employed monthly data for the period Jan 2010 - Dec 2022. Using Structural Vector Autoregressive (SVAR) Model, the study captured price dynamics through the three channels of foreign exchange, inflation and lending rates. All data was obtained from the Central Bank of Kenya online repositories. The empirical assessment of this paper leads to three broad insightful conclusions. First, from policy front, monetary policy is not fully effective in controlling and stabilizing prices especially inflation; two, expansionary fiscal policy is not only inflationary but leads to higher interests' rates as well and three: there exists traces of fiscal dominance even though it does not appear to very high form of fiscal dominance (which this study calls the slow intrusion of fiscal policy into the monetary policy space). The study therefore concludes that while fiscal dominance may not be very pronounced, there is need to review the interplay between monetary and fiscal policies to fully gain from the interdependence of the two policies by stabilizing prices and enhancing growth as expected and avoid macro-economic instability that comes with fiscal dominance. The paper recommends reducing government borrowing especially domestic borrowing, cutting unnecessary spending, directing spending towards development projects like infrastructure or social-economic projects and sectors that support or influence growth; establish the necessity of currency pegging to avoid unpleasant multiplier effect of fiscal dominance, review the emergence and effects of dollarization in Kenya and lastly review of fiscal policy and establish if there is a need for a Fiscal Policy Committee (FPC).