Estimating a time varying Nairu and the output gap for a developing country : A Kenyan case

Abstract

This study estimates the NAIRU and the output gap for the Kenyan economy. This is very important in analysing the direction of macroeconomic policies towards attaining a sustainable non-inflationary growth. The question addressed in this study is whether these two concepts are important in directing policies in a developing country. The NAIRU has been estimated using the Phillips curve while the output gap has been obtained via the production function approach. Okun's law has also been used to investigate the relationship between the output gap and the labour market gap. The estimated NAIRU for the year 2001 is found to be 9.03 per cent. This is less than the observed rate. This suggests that unemployment can be reduced without causing accelerating inflation. The estimated potential output growth for the year 2001 is 10.4 per cent. There is a negative output gap of - 4.29 for 2001 meaning that there is excess capacity in the economy. There is a negative relation between the two gaps and structural analysis suggests that the output gap is determined by the labour market gap. From these results, a combination of policies is suggested. Employment can be increased through an expansive fiscal policy and a loose monetary policy. This should also be coupled with a well-directed government spending so as to achieve a sustainable non-inflationary economic growth. Alternative results obtained using an adjusted level of employment give a NAIRU level of 31 per cent in 2001. This suggests that different unemployment rates will yield different results, hence the recommendation for a detailed study using different estimation methods and better data set on unemployment to compare the results .