Relationship Between Fiscal Dominance And Selected Macroeconomic Variables In Kenya

ABSTRACT

Over the past four decades, Kenya has been experiencing fiscal instability with

average fiscal deficit as percent of GDP being greater than 5 percent threshold

for developing countries. This, together with poor donors’ relations in the

1980’s, and the substitution of foreign borrowing with internal borrowing has

led to continued increase in fiscal dominance. Kenya has been unable to reach

the 10 percent economic growth target required for realization of Kenya’s Vision

2030, with annual economic growth in 2017 being 4.9 percent even with

increasing fiscal dominance. Fiscal dominance as a percent of GDP has been

moving in the same direction as inflation rate. In 2017, inflation rate reached 8

percent, a rate that is higher than 5 percent CBK target with 2.5 percent margin

on either side. Fiscal dominance remains a vital worldwide debate especially for

countries experiencing large and persistent fiscal deficit. The question being

whether or not fiscal dominance affects price stability of a country and whether

or not it stimulates economic growth in developing countries and emerging

economies with large fiscal deficits. The general objective of the study was to

determine the effects of fiscal dominance on selected macroeconomic variables

in Kenya. The specific objectives were to determine the effects of fiscal

dominance on inflation rate and to analyze the relationship between fiscal

dominance and economic growth in Kenya. The study utilized annual

quantitative time series data for the period 1976-2017. The study employed

Autoregressive Distributed Lag model to estimate the short run and long run

effects of fiscal dominance on inflation rate in Kenya. Granger causality test was

used to determine the direction of causality between economic growth and fiscal

dominance. The study found that fiscal dominance had a negative effect on

inflation rate in the current period. However, the coefficients became positive

and statistically significant at 5 percent level of significance after the first year

and in the long run. The study also found that fiscal dominance granger causes

economic growth in Kenya. Using impulse response functions derived from

restricted Vector Autoregressive coefficient, the study found that fiscal

dominance had negative impacts on economic growth in the short run but the

impact became positive in the long run. The study therefore concluded that,

fiscal dominance has adverse effects on inflation rate and on economic growth

in the short run. However, it stimulates economic growth in the long run. The

study recommends that, Central bank of Kenya should remain fully independent

to reduce fiscal dominance.