Maureen Gathuu, George Kosimbei
Abstract: Price inflation has continued to manifest itself on the macroeconomic scene becoming an area of concern to many policy makers. This study analyzes the impact of money supply, exchange rate, oil prices and interest rate on inflation using Vector Error Correction Model and monthly data for the period 2003-2013. Johansen Co-integration Analysis was conducted to establish the presence of cointegration. Causality between the variables was ascertained using Granger causality tests. According to the VECM model estimated, all the variables except exchange rate have positive and significant effects on the fluctuation of the Consumer Price Index (CPI) in long run. Considering the short run effects of these variables on inflation, only interest rate and money supply are statistically significant. In reference to granger causality, it was observed that changes in CPI granger cause changes in crude oil prices and changes in interest rates granger cause changes in CPI. On the basis of the findings, the study concludes that inflation in Kenya is triggered by both demand and supply side factors but crude oil prices and money supply are most critical. Several policy implications have been provided to mitigate the effects of interest rate, exchange rate, oil price shocks and money supply on inflation.
Keywords: Inflation, Vector Error Correction Model, Causal relationship, Interest rates, money supply