The Effect of External Debt on Inflation Rate in Kenya, 1972-2012

Abstract

The purpose of the paper was to review existing studies on external debt and inflation and establish the effect of external debt on inflation in Kenya over the period of 1972-2012. The study used real annual time series data obtained from IMF International Financial Statistics database. The time series data was tested for stationarity using Augmented Dickey-Fuller (ADF), tests for heteroskedasticity, autoregressive conditional heteroskedasticity (ARCH), autocorrelation and normality were done to ensure the data does not violate the assumptions of classical linear regression model (CLRM). A macroeconomic debt growth model using ordinary least square regression was used to estimate the relationship between external debt and inflation. Descriptive statistics indicates that Kenya experienced high levels of inflation, with mild fluctuations. The highest levels of inflation were recorded in 1991 and 2008, due to the OPEC oil crisis and post-election violence, respectively. In terms of correlation, the study reveals that external debt and inflation showed that external debt and inflation are negatively correlated, with a Spearman's correlation coefficient of -0.1768 with a P value of 0.2687. Regression results showed that external debt has a positive and significant effect on inflation, with an F statistic of 7.14 with a P value of 0.011. The study concludes that there is a significant effect of external debt on inflation. The study recommends sustaining lower inflation rates through tight fiscal and monetary policies, financing of budget deficit from non-inflationary sources, implementation of price stabilization program by subsiding basic food items, and effectively managing external debt.