Exchange rate pass-through to domestic prices in Kenya: 1972-2004

Abstract

This study assesses the extent to which exchange rates affect consumer prices in Kenya i.e. the exchange rate pass-through to consumer prices. The analysis covers the period 1972-2004. The study uses two different approaches which are based on vector autoregressive (V AR) models. The first one uses an unrestricted V AR model while the second uses the Johansen framework of multivariate cointegration. It is shown that exchange rate pass-through is incomplete and is 0.4, which implies that 10% increase in exchange rates leads to 4% rise in consumer prices. These findings are consistent with past studies on pass-through in Kenya and other countries. The study also confirms the significant effects of import prices on inflation in Kenya. Pass-through from import prices to consumer prices is 0.70. Therefore, import prices have greater effects on consumer pnces (P) since 10% increase in import prices leads to 7% increase in consumer pnces. Other results are that money supply has significant positive long-run effects on prices (P). 10% increase in money supply leads to 3.8 % increase in prices (P). Foreign interest rates also have significant positive effects on prices. 10% increase in foreign interest rates results in 1.5% increase in prices. In a similar manner, 10% increase in output leads to 10% increase in prices in the long-run. The negative sign on the output coefficient could represent effects of such shocks as drought on inflation. During drought, food prices rise and output declines, producing a negative relationship between output and consumer prices. Another notable finding is that the impact of money supply and import price shocks on prices reaches its peak in the second period and that own shocks have significant effects on consumer prices.