Fiscal Lags deficit financing and inflation; Kenya 1967- 86

Abstract

Studies on inflation in Kenya have, from time to time, emphasized the importance of money supply as a cause of inflation and have consequently recommended strict monetary control. If money supply directly influences the price level, then a two-way causation between fiscal deficits and inflation may occur, depending on the nature of the impact of inflation on government revenues and expenditures. The results in this paper have shown that there is a causal link running from inflation to the fiscal deficit and none from the latter to the former. While a direct causal link from money supply to inflation has continually been suggested, there is evidence that this link is indirect with money supply affecting exchange rates which, in turn, affect import prices and, hence, inflation. This is attributed to the exchange rate adjustments of the 1970's and the flexible exchange rate policy which became operational in the 1980's. Inflation originating from rising import prices is likely to be self perpetuating as it will possibly widen the trade deficit; inducing further devaluation and leading, eventually, to higher import prices and, consequently more inflation.