Institute for Development Studies, University of Nairobi

The paper analyses the dynamics of inflation in Kenya by assessing the relative importance of monetary and external factors. This is done through a multivariate Granger-noncausality tests and the decomposition of the forecast error variance into variable specific innovations Using Granger-noncausality tests the study finds that monetary base growth, exchange rate movements, real income growth, the foreign rate of inflation and interest rate movements have significant effects on inflation. The monetary base growth, interest rate1 and exchange rate movements have strong feedback effects with inflation. This implies that a shock on any of this variables, including the rate of inflation will not peter out rapidly (not transitory) but will have permanent effects. Broad money, M3, on the other hand, is driven by inflation without feedback effects. These results point to the differential impact of the two money supply aggregates on the rate of domestic inflation. Using variance decomposition, the exchange rate was found to be the most important variable accounting for half of the innovations in the price level. The paper thus concludes that exchange rate movements are more important than money supply growth in explaining Kenya's inflationary process.