EFFECTS OF INFLATION AND UNEMPLOYMENT ON ECONOMIC

GROWTH IN KENYA - 1995 TO 2004.

BY

KHAGGAYI RONALD INGALA

ECO/010/01

SUPERVISOR

DR. P.L. ONSANDO

ECO 420: RESEARCH PAPER

DEPARTMENT OF ECONOMICS AND AGRICULTURAL RESOURCE MANAGEMENT

SCHOOL OF BUSINESS AND ECONOMICS

MOI UNIVERSITY

P.O. BOX 3900

ELDORET.

A RESEARCH PAPER IN PARTIAL FULFILLMENT FOR THE AWARD OF BACHELOR OF ARTS

DEGREE IN ECONOMICS.

© AUGUST 2005
 DECLARATION

I declare that this is my original work, and it has not been submitted to any other institution

of higher learning.

Sign: Date:

This research dissertation has been submitted for examination with my approval as the

university supervisor.

Sign: Date:

i
 DEDICATION

This dissertation is dedicated to them who,

When there was darkness you held the candle for me to see,

In the rain you held my hand not to fall,

When I was lonely you held me close.

Walking with me along the way, a journey that had ups and down,

My success is your success.

ii
 ACKNOWLEDGEMENT

The journey has been tough, from commencement to completion of this study; I received

tremendous help, cooperation, support and encouragement from different authorities, friends

and family. First of all, I express my deepest sense of gratitude to the authorities of Moi

University who kindly admitted me as an undergraduate student and permitted me do this

study for the award of a Bachelor of Arts degree in Economics.

I express my indebtness to my supervisor, Dr. P.L. Onsando under whose guidance I was

able to complete this research

To the Economics department lecturers who have imparted in me the knowledge that I have.

Special thanks to Dr. M.M.M. Kadenyi, a mother, true friend and mentor who was there

when I was about to give up. Thank you for you great assistance, it is much less than you

deserve.

I would also like to record my appreciation to Rono who assisted me in typing this

manuscript. Friends like Sawe, Njuga, Sammy, Njiriri and many others who gave me hope

when there was none.

Last but not least to my family for their tireless efforts towards ensuring my academic

success. Their support financially, socially and emotionally was always there for me. While

expressing my deepest sense of gratitude, words elude me to express my indedtness to them.

This is all for you. It will not be an exaggeration to say that by thanking them am thanking

myself. To God is the glory for seeing me through the period of study.

iii
 ABSTRACT

GDP is a measure of aggregate activity hence an important macro-economic variable. But,

two other variables; unemployment and inflation tells us about other important aspects of

how an economy is performing.

Inflation affects a country’s growth, which may slow the rising trends of the economy.

Inflation will determine the general price level in the economy and therefore of much

importance to both producers and consumers.

Unemployment rate is the ratio of the number of people who are unemployed to the number

of people in the labour force. Why care about unemployment? It is an indication of whether

the economy is operating above or below its normal level of activity. In addition it is often

associated with social consequences and affects the welfare of the unemployed.

Unemployment rates in Kenya have remained relatively high.

Over the period between 1995 and 2004, the economy has shown mixed signals (no general

trend of increase in growth or decrease). This is also the case for inflation where in one

period there is high inflation followed by a period of low inflation.

The research is an investigation into the effect of inflation and unemployment on economic

growth over the period. The findings of this paper indicate that there is a negative

relationship between economic growth, inflation and unemployment.

The government should come up with the necessary policies to counter the negative effects

of unemployment and inflation on economic growth. There are positive signs of economic

growth while unemployment rate is decreasing with lower levels expected in future.

iv
 TABLE OF CONTENTS

Declaration i
Dedication ii
Acknowledgement iii
Abstract iv
List of acronyms vi
List of figures vii
CHAPTER ONE 1
1.0. INTRODUCTION 1
1.1. Background of the Problem 1
1.2. Statement of the Problem 2
1.3. Statement of Objectives 3
1.3.1. Broad Objective 3
1.3.2. Specific Objectives 3
1.4. Statement of Hypothesis 4
1.5. Justification of the Study 4
CHAPTER TWO 6
2.0. LITERATURE REVIEW 6
CHAPTER THREE 11
3.0. RESEARCH METHODOLOGY 11
3.1. Research Design 11
3.2. Sampling Design 11
3.3. Data Collection 12
3.3.1. Secondary Data 12
3.4. Data Presentation and Analysis 12
3.4.1. Conceptual Framework 12
CHAPTER FOUR 14
4.0.0. DATA ANALYSIS 14
4.1.0. Inflation, Unemployment and Economic Growth over the Period 14
4.2.1. The Regression Model 16
4.2.2. Trend Analysis 18
CHAPTER FIVE 21
5.0.0. FINDINGS, CONCLUSION AND RECOMMENDATIONS 21
5.1. Findings 21
5.2. Conclusion 22
5.3. Recommendations 23
Limitations of the Study 24
REFERENCES 25
APPENDICES 26
APPENDIX I 26
APPENDIX II 33

v
LIST OF ACRONYMS
CBS – Central Bureau of Statistics

CBK – Central Bank of Kenya

KDHS – Kenya Domestic and Household Survey

GDP – Gross Domestic Product

GNP – Gross National Product

vi
LIST OF FIGURES

Table 4.1. Summary of Inflation rate, Unemployment rate and the Real GDP growth rate between

1995 and 2004 in Kenya 15

Table 4.2. Mean of the Variables 16

Table 4.3. Estimates b0, b1 and b2. 16

Graph 1: Inflation, Unemployment and GDP growth versus Time 18

Graph 2: Inflation Rate and GDP growth Rate 20

Graph 2: Unemployment Rate and GDP growth Rate 20

Chart 1: Real GDP rates, 1998 – June 2004 33

vii
CHAPTER ONE

1.0. INTRODUCTION

1.1. Background of the Problem

The recently presented Kenyan budget did not state the rate of monetary expansion to be

targeted. The monetary expansion rate determines the inflation rate in a country. With

reported growth in the economy in the year ended July 2004 to June 2005, the Kenyan

economy grew by 4.6%. The budget was presented as a poor man’s budget, however,

inflation ends up hurting the poor most in present day Kenya and they too feel the pinch of

unemployment.

Inflation is a continuous increase in the price level, sustained over a period of time. Inflation

may be caused by a continuous increase in the supply of money, a continuous decrease in the

demand for money, or a combination of the two. Government might very well and often do

increase the money supply continuously. If the demand for money were fixed, then the price

level would grow at the same rate as money supply. Rising real incomes usually cause the

demand for money to rise over time. This tempers the inflationary effect of money supply

growth, and so the price level typically grows more slowly than the money supply. Even so, a

higher rate of money supply growth is expected to cause a higher rate of inflation.

The term unemployment does not necessarily mean the number of people who are without

employment. The unemployment rate is the percentage of the labour force that is without

employment. Unemployment can mainly be classified as voluntary unemployment, which is

unemployment that occurs because individuals choose not to accept available jobs at the

current wage rate, and involuntary unemployment, which is as a result of the quantity of

labour, supplied exceeding the quantity demanded for labour at the going wage rate.

1
Unemployment can be further divided into cyclical unemployment, frictional unemployment,

structural unemployment and seasonal unemployment. Cyclical unemployment is more

common which arises from the business cycle.

Full employment is achieved when everyone who is willing to work and is able to work has a

job. This state of economy is hard to achieve. Serious unemployment must be avoided

because of its economic consequences for the total economy and the hardships it brings to

individuals and families.

Inflation and unemployment are normally referred to as the twin evils and have detriments to

the economy.

1.2. Statement of the Problem

In the calculation of GDP, most economists do not account for the effects of inflation and

unemployment on the overall performance of the economy. Economic growth has been

pegged to the GDP measure; a measure of output to evaluate the state of the economy.

National income accounts are a measure of output in terms of prices. In determining the

market prices, National income accounts do not factor in the effect of inflation on the prices

of goods and services. For example, if the cost for a packet of Unga between the year 2003

and 2004 rose by Kshs.10, will this increase be due to economic growth especially in the

manufacturing sector or will it be attributed to inflation?

Thus, an increase in prices may reflect an increase in output, which will be reflected in the

increased GDP amount holding inflation constant which in not the case.

Inflation is computed separately mainly through the consumer Price Index (CPI) and the

GNP-deflator, but ignored in major reporting of the economic growth.

2
Employment contributes towards the overall calculation of the GDP in terms of wages and in

some cases man-hours used in production processes. However, the effects of unemployment

are more severe on the economy in that it reduces the amount of disposable income being

held by families or households.

The unemployment ratio is mainly used to describe the hardships of the people who are

willing to work and are actually striving to do so. Their effect on the economic growth model

of an economy or nation is not given in clearly defined terms.

Since inflation and unemployment affect the general economic behaviour, a more

comprehensive study needs to be undertaken to establish where any relationships subsists

between inflation and unemployment to economic growth.

1.3. Statement of Objectives

1.3.1. Broad Objective

• To understand and explain the factors that contribute to the behaviour of the

economic growth model of Kenya from 1995 to the year 2004 and study the effects

of inflation and unemployment on the Kenyan economy.

1.3.2. Specific Objectives

• To study and explain how inflation affects the growth rate of the economy through

its effects on the purchasing power of consumers.

• To study and explain unemployment as a hindering factor to the attainment of

higher rates of growth of the economy.

3
 • To analyze and determine the relationship between inflation, unemployment and

economic growth in the period from 1990 to 2004.

1.4. Statement of Hypothesis

• High rate of inflation and unemployment leads to a low growth rate of the

economy.

• Increase in the rate of inflation and unemployment rate corresponds to an increase

in the economic growth rate.

• High rates of economic growth are not as a result of low levels of inflation and

unemployment.

1.5. Justification of the Study

Inflation and unemployment are referred to as the two evils of the economy. Though not

tangible, they affect the majority of the population. Its effects are felt directly by all persons

ranging from the rich and more so among the poor of the population. Unemployment is

chronic and intractable in nearly every developing country. Unemployment rates in Kenya

have held the two-digit percentage over the period under study (1990-2004).

The relationship between inflation and unemployment affect the other and hence, it is only

proper to consider their total effects on the economic growth of a country. An analysis of

both helps in the development of a monetary policy that will assist in achieving a positive

growth in the economy.

Inflation and unemployment cannot be cured simply by accelerating growth. More so, their

direct relationship or effects on economic growth have been ignored.

4
As long as unemployment and inflation exists, it will be a precursor to multiple economic

problems. For example, increased inflation rates lead to a reduction in the purchasing power

of households hence a reduction in aggregate demand. High levels leads to low incomes,

which may further lead to low savings and investment levels.

This study aims at helping understand and find solutions to the twin problems of inflation

and unemployment and their effect on economic growth.

5
CHAPTER TWO

2.0. LITERATURE REVIEW

National income accounts and other related accounts do not cover all of the important

measures of economic performance. Inflation and unemployment are not only more visible to

unsophiscated observers, but they have formed the basis of most policy initiative of many

past years. [Robert E. Hall and John B. Taylor].

Inflation is measured by a price index that is not part of the accounts, though it is closely

related to most components of the national income accounts like consumption levels.

Unemployment, while it is possibly a most important dimension of performance, it is not part

of the national income accounts at all.

The above sentiments further highlight the point that, in the computation of national income

mainly given in terms of output (GNP does not consider inflation and unemployment),

ignorant of the fact that they affect the whole economy both directly and indirectly.

Both inflation and unemployment are economic problems that affect the trend of economic

activities. The trend of inflation and unemployment in an economy will determine future

macroeconomic policies to be undertaken in an economy. Thus, in making future decisions,

the information available should be abit error-free, as is expressed that;

“When making decisions, people think about the future, and their expectations of the

future can be modeled by assuming that they have a sense of economic fluctuations

and use their information to make unbiased (but not error-free) forecasts.”1

Economic fluctuations like inflation and unemployment are recurrent from one business

cycle to another and hence need to be considered in dealing with overall economic

performance of Kenya.
1
Robert E. Hall and John B. Taylor, Macroeconomics: Theory, Performance and Policy, pg.478.

6
Macro policy makers try to achieve the best combination of employment and inflation for an

economy. This means that, though not reflected in the overall GNP figure annually and hence

avoided in deciding the level of economic growth, inflation and unemployment are still

considered by macro policy makers as vital and important in any economy.

Inflation is measured as a rate of change in price index from one period to the next.2 Inflation

is not an increase in all prices. it is instead, an increase in the general level of price and

costs. Deflation is exactly the opposite, and disinflation is a reduction in the rate of inflation.

The rate of inflation is the percentage change in the average price of all goods in the

economy.

Inflation is defined as a time of generally rising prices for goods and factors of production.

In any economy inflation is undesirable. This is because of the specific economic costs

associated with inflation. First, when inflation is high, currency and non-interest-bearing

checking accounts are undesirable because they are constantly declining in purchasing

power. Secondly, there are tax distortions, for example, when inflation rages, the actual value

of these deductions are much less than it should actually be. There are also unfair gains and

losses. When inflation hits, some people gain and some lose for example people whose

pensions are fixed in shilling terms lose.

People see inflation as a breakdown of the basic government responsibility to provide a

stable unit of purchasing power. Some people may not understand the relation between their

own incomes and rising prices. To them, higher prices represent diminished real income.

The marginal social cost of unemployment is higher when unemployment is high. Since

labour supply is inelastic, the marginal value of time in other uses falls if unemployment

rises, and rises if unemployment falls below normal levels. Therefore, the economy is better
2
Gary W. Yohe, Study Guide to Accompany Samuelson-Nordhaus Macroeconomics.

7
off with stable output at optimal employment level, as against fluctuating output and

employment. [Robert E. Hall and John B. Taylor].

Economists are quick to recall Okun’s Law when they are asked to evaluate the economic

costs of unemployment. It is a shorthand formula that closely approximates the cyclical

relationship between unemployment and real GNP.

Okun’s Law says that, for each percentage point by which the unemployment rate is above

the natural rate, real GNP is 3 percent below potential GNP. The percentage of GNP from

potential is called the GNP gap.

The movement in unemployment is closely related to the movement in the percentage

departures of real GNP from potential GNP. The slope of the relationship is roughly 3

percentage points of real GNP for each percent of unemployment.3

Gary W. Hoye (Ibid) notes, Economists are quick to recall Okun’s Law when they are asked

to evaluate the economic cost of unemployment. These loses are astronomical when they are

compared with the efficiency costs of monopoly and other forms of imperfect competition,

the costs of strict environmental controls or even the estimate waste in government spending.

Nonetheless, it misses the human cost: the cost of repairs when homes are broken by the

unemployed people, anguish of workers in thousands who show up to any interview among

others. To him, unemployment is one of those topics that bring dismal science out of the

tower of numbers and make it a social science.

This is to mean, even the unemployment figures have shortcomings in themselves and hence

their full impact on the economy cannot be fully comprehended.

Studies that have been made on inflation and unemployment on the same analysis mainly

centre on the trade-off between inflation and unemployment giving the Phillips-curve
3
Robert E. Hall and John B. Taylor, pg.60.

8
analysis. The Phillips-curve analysis however will hold only when unemployment is below

the natural rate, which is hard to achieve by many countries especially in LDCs and

developing countries, Kenya included.

At the natural rate of unemployment and the inertial rate of inflation in short and long-run

curves, unemployment rates lower than the natural rate are associated with inflation above

the inertial rate.

Inertial inflation is expected and sustained because it is built into contracts and other

financial agreements. Inertial inflation therefore reflects an internal rate of inflation with

which an economy seems to be comfortable. Individuals expect it, and expectations tend to

become self-fulfilling prophecies.4

There are various types of inflation. Demand-pull inflation is the result of excessive

aggregate demand and can be associated with higher levels of real as well as nominal GNP.

Cost-push inflation is caused by increased costs, which push aggregate supply up; it is

therefore associated with lower levels of real GNP, nominal GNP can be higher or lower.

Modern theory suggests that there is no trade-off between inflation and unemployment in the

long-run; the long-run Phillips curve is therefore vertical at the natural rate of

unemployment.5 No economy has yet managed to maintain full employment over long

periods of time with stable prices and free markets.

It is not easy to measure the precise amount of impact of or arising from higher inflation

experienced among population in their respective income groups. Higher inflation stems

from higher prices of goods and services consumed across the economy. [Central Bank of

Kenya.]

4
Ibid, pg.175.
5
Ibid, pg.181.

9
The Kenyan overall inflation in the month of May 2005, overall inflation has been on a rising

trend due to several factors, which include; development in food prices, development in

energy costs, lagged effects of monetary expansion and high increases in wages.6

Similarly, the unemployment levels have been on the rise. More so, the Kenyan economy has

recorded a positive growth of 4.6% of GNP.7 The relationship between inflation,

unemployment and economic growth though not directly can be put in economic terms. High

levels of inflation and high levels of unemployment lead to a situation of stagflation.

6
CBK Monthly Review, May 2005.
7
Economic Survey 2005.

10
CHAPTER THREE

3.0. RESEARCH METHODOLOGY

3.1. Research Design

This research seeks to explain a casual relationship between inflation, unemployment and the

rate of economic growth in Kenya.

In the development of the research, a regression model is designed is designed from

secondary data giving annual figures of the dependent and independent variables in the

model. The data is used to develop, and prove the reliability of the model hence assist in the

explanation of the relationship between inflation, unemployment and economic growth.

The annual inflation rate is generated by the Central Bank of Kenya and published in its

Annual Report of 2004. To give a nationwide outlook, the implicit price deflator is used. The

unemployment rate is generated from employment figures in the Annual Statistical Abstract8

by the Central Bureau of Statistics and the working population figures from the Kenya

Domestic and Household Survey by the Central Bureau of Statistics in 2004.

Economic growth rate is as presented in the Kenya Economic Survey by the Central Bureau

of Statistics.

3.2. Sampling Design

A 10-year period between 1995 and 2004 was selected on which the research was based. The

period between 1995 and 2004 is representative enough in analyzing the relationship that is

present between the variables (inflation, unemployment and economic growth).

The period between 1995 and 2004 to consist of sample data has undergone several phases

like economic recovery just after the 1992 general elections, a stagnant period between 1997
8
CBS, Statistical Abstract 2004.

11
and 1999, and a recession period, which was heavily felt in 2000. The economy has been on

a recovery path from the year 2002 onwards.

3.3. Data Collection

3.3.1. Secondary Data

Data collected for the research was from secondary sources mainly found in official

government publications and other government departments like the Central Bank of Kenya.

Secondary data was useful in building the regression model and conducting tests thereon.

Data was collected from publications like:

− The Economic Survey 2005

− The Statistical Abstract 2004

− The CBK Annual Report 2004

− The CBK Monthly Review for May 2005.

3.4. Data Presentation and Analysis

3.4.1. Conceptual Framework

This research set out to investigate the effect of inflation and unemployment on economic

growth in Kenya. This relationship is designed on a multiple regression model assuming a

linear relationship between the variables. The model is given as;

Y = b0 + b1 X 1 + b2 X 2 + u
Where;

Y is the economic growth rate

X1 is the inflation rate

12
 X2 is the unemployment rate

b0, b1, b3 are constant coefficients.

It is assumed that the random variable U has a normal distribution with zero mean;

Ε(u ) = 0

This reduces the estimation model to;

Y = b0 + b1 X 1 + b2 X 2
The significance of the model was determined by testing for the variation in Y as explained

by X1 and X2 using the R2.

The student t-test is conducted on the variables to determine the significance of the variables

in the model.

13
CHAPTER FOUR

4.0.0. DATA ANALYSIS

4.1.0. Inflation, Unemployment and Economic Growth over the Period

Over the 10-year period from 1995 to 2004, the growth rate of the economy did not show a

steady or regular pattern. In the year 1995 and 1996, the rate of economic growth in real

GDP was 4.8% and 4.6% respectively. This is the highest growth recorded over the period.

However, in the year 1997, the growth rate went to dismal levels of 0.5% and this may be

attributed to being a period when general elections were being held, then the government was

focusing more on re-election into office rather than economic prosperity.

The lowest level of economic growth to be achieved in Kenya economy was in the year 2000

with a real GDP growth rate of 0.2% but rose in following years to 4.3% in 2004.

The unemployment level in Kenya has been very high. Nearly half the Kenyan population is

unemployed.9 The available statistics show that, unemployment was higher between 1997

and 2002 but the unemployment was higher between 1997 and 2002, but began falling in the

years 2003 and 2004. This may be attributed to the various policies initiated by the new

NARC government which came into power on a platform of creating employment

opportunities – ‘500000 job opportunities per year’ – and focusing on economic growth. Still

unemployment levels are still high with structural unemployment being rampant in Kenya as

people become desperate for employment.

The inflation rate has generally been maintained at one figure level. Between 1995 and 1996,

the government was able to confine underlying inflation within the single digit range. This

was mainly due to tight monetary policy introduction by the Central bank of Kenya.
9
The employment figures in the Statistical Abstract published by the CBS include casual workers, part-time
employees, part-time workers, directors and partners serving on a regular basic salary contract. A portion of
self-employed persons and family workers who do not receive regular wages are excluded. Also excluded are
employment from informal sector, rural small-scale agriculture and pastoralists activities.

14
However, in 1997, inflation shot up to 11.9%, reason being that it was period when general

elections were held in Kenya, there were cases of bribery and excess circulation of liquid

money in the country.

Higher inflation is also seen in the year 2000 and in the year 2004, mainly being as a result of

increasing commodity prices as influenced by rising world oil prices.

Table 4.1. Summary of Inflation rate, Unemployment rate and the Real GDP growth rate between

1995 and 2004 in Kenya.

Year Interest Rate Unemployment Real GDP growth

(%) rate10 (%) (%)
1995 01.6 47.6 4.8
1996 08.9 48.4 4.6
1997 11.9 51.3 0.5
1998 06.7 50.7 3.3
1999 05.8 50.1 2.3
2000 10.0 49.8 0.2
2001 05.8 51.6 4.4
2002 04.2 49.4 1.2
2003 09.8 45.3 1.8
2004 11.6 44.3 4.3
Source: 1. Inflation Rates; CBK Annual Report 2004.
2. Unemployment Rates; Statistical Abstract 2004 and The KDHS Survey 2004.
3. Real GDP growth; Economic Survey 2005 and CBK Annual Report 2004.

High rates of unemployment over the period may be attributed to a previous high population

growth rate, coupled with lack of opportunities for employment. In the year 2001,

investments were low and many companies were closing down moving out of the country

and relocating to other areas with cheap operating costs. For example, World Hope

organization closed its HQs in Kenya and relocated to Tanzania citing high costs of

operation. In addition, due to political uncertainty, investment level was very low.

10
See footnote 11.

15
 4.2.1. The Regression Model

Table 4.2. Mean of the Variables

n Real GDP growth Inflation Rate Unemployment Rate

Y X1 X2
1 4.8 1.6 47.6
2 4.6 8.9 48.4
3 0.5 11.9 51.3
4 3.3 6.7 50.7
5 2.3 5.8 50.1
6 0.2 10 49.8
7 4.4 5.8 51.6
8 1.2 4.2 49.4
9 1.8 9.8 45.3
10 4.3 11.6 44.3
∑Y =76.3 ∑X1 = 27.4 ∑X2 = 488.5
Note: All values are in percentage

Table 4.3. Estimates b0, b1 and b2.

Interest Unemployment Real GDP

Rate Rate Growth
Year y x1 X2 y x1 x2 y2 x12 x22 yx1 yx2 x1x2
1995 1.6 47.6 4.8 2.06 -6.03 -1.25 4.2436 36.3609 1.5625 -12.4218 -2.575 7.5375
1996 8.9 48.4 4.6 1.86 1.27 -0.45 3.4596 1.6129 0.2025 2.3622 -0.837 -0.5715
1997 11.9 51.3 0.5 -2.24 4.27 2.45 5.0176 18.2329 6.0025 -9.5648 -5.488 10.4615
1998 6.7 50.7 3.3 0.56 -0.93 1.85 0.3136 0.8649 3.4225 -0.5208 1.036 -1.7205
1999 5.8 50.1 2.3 -0.44 -1.83 1.25 0.1936 3.3489 1.5625 0.8052 -0.55 -2.2875
2000 10 49.8 0.2 -2.54 2.37 0.95 6.4516 5.6169 0.9025 -6.0198 -2.413 2.2515
2001 5.8 51.6 4.4 1.66 -1.83 2.75 2.7556 3.3489 7.5625 -3.0378 4.565 -5.0325
2002 4.2 49.4 1.2 -1.54 -3.43 0.55 2.3716 11.7649 0.3025 5.2822 -0.847 -1.8865
2003 9.8 45.3 1.8 -0.94 2.17 -3.55 0.8836 4.7089 12.6025 -2.0398 3.337 -7.7035
2004 11.6 44.3 4.3 1.56 3.97 -4.55 2.4336 15.7609 20.7025 6.1932 -7.098 -18.0635
Total 76.3 488.5 27.4 28.124 101.621 54.825 -18.962 -10.87 -17.015
From the calculations11 the estimates are;

b0= -8.68

b1= -0.232

b2= -0.27

Therefore, the true regression model is given by;

Y=-8.68-0.232X1-0.27X2
11
See Appendix

16
This true regression model shows both inflation and unemployment have an indirect

relationship with the real growth of the economy, that is, the real GDP growth rate.

This means that an increase in inflation and unemployment will lead to a decrease in the level

of economic growth.

Testing the Significance of the Model12

From the student t-test;

-1.96<tc<1.96

For b0, b1 and b2, they all fall in the critical region with the value of –0.751, 1.013 and 1.607

respectively. With the tc falling in the acceptance region i.e. –t0.025<tc<t0.025, we accept the null

hypothesis and conclude that the variables are not significant in explaining the model. This

means the t-test shows there is casual relationship between inflation rate, unemployment rate

and new real GDP growth.

4.2.2 Trend Analysis

12
See Appendix

17
 GRAPH 1: INFLATION, UNEMPLOYMENT AND GDP GROWTH VERSUS TIME

70
INFLATION , UNEMPLOYMENT, REAL GDP

UNEMPLOYMENT
60

50
GROWTH (%)

40

30

20
INFLATIO
N
10 REAL
GDP
0 GROWT
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

YEARS

Over the period [1995-2004], unemployment rates have remained at high levels. Between

1997 and 2003, unemployment rates remained stable at high levels. The rates of

unemployment however began to fall from the year 2003 to lower levels in 2004.

Inflation has also remained at higher levels than real GDP growth. Inflation was high in 1997

and in 2000 and lowest in the year 2002. Since 2002 to 2004, inflation has been on the rise

with higher levels projected in 2005. Overall inflation has been on a rising trend since the

year 2000. The rising trend in overall inflation is due to the following:

• Developments in food prices: delayed rains in the 2000 and 2001 put pressure on

the prices of basic foodstuffs such as vegetables and fruits thereby pushing up the

food basket prices. In addition, the recent sugar shortage contributed to the

inflationary pressures through increases in sugar prices.

18
 • Developments in energy costs: oil prices have remained consistently high, in the

range of US$ 55-60 per barrel in the international market, thereby resulting in

higher pump-fuel prices in the domestic economy. The high oil prices also imply

higher transport costs and higher costs for commodities whose production uses oil

as an input.

• The lagged effects of monetary expansion.

• Demand pressures arising from huge increases in wages, especially in the public
sector (teachers, nurses, the police, members of parliament, the Judiciary and other
government officers).

Real GDP growth at low levels over the period with the lowest level in 200 at 0.2 % . From
the year 2002 to 2004, GDP growth in increasing with a higher level of expected in the year
2005.
An increase in real GDP growth rate is accompanied by an increase in inflation rate. This is
observed between the years 2002 to 2004.

There is no linear relationship that can be easily denoted or graphed out of the data collected.
This shows that, the relationship that is between inflation rate, unemployment rate and real
GDP growth rate is not a linear one. This is seen if each variable is plotted against GDP
growth rate, the points are scattered on the grid as shown in the graphs below.

19
 Graph 2: Inflation Rate and GDP growth Rate

14
12

10
Inflation (%)

8
6

2
0
0 1 2 3 4 5 6
GDP growth (%)

Unemployment rate (%) and GDP growth Rate

52
51
Unemployment Rate (%)

50
49
48
47
46
45
44
43
0 1 2 3 4 5 6
GDP growth (% )

20
CHAPTER FIVE

5.0.0. FINDINGS, CONCLUSION AND RECOMMENDATIONS

5.1. Findings

The basic economic model for the relationship between inflation, unemployment and

economic growth in Kenya is given by;

Y = − 8.6 8− 0.2 3 2X 1 − 0.2 7X 2

This basic model shows that there is an inverse relationship between inflation rate,

unemployment rate and real economic growth rate.

Inflation and unemployment rates account for 30.4% of the changes in economic growth. The

variables are not very significant in determining the model of economic growth.

Over the period from 1995 to the year 2004, the unemployment rates remained at high levels.

Variations in unemployment remained low. In trend analysis, from 1997 to 2002, the rates of

unemployment remained at near constant level but at very high rates. Slight decreases are

recorded between the years 2002 and 2004.

With high levels of unemployment rate and inflation, economic growth still remains at low

levels. Increase in the real GDP growth does not correspond to decreases in inflation and

unemployment rates.

Between the year 2002 and 2004, an increase in real GDP growth rate related to an increase

in inflation but during the same period there was a decrease in unemployment rate.

From 1996 to 1998, the relationship merely holds where economic growth rate corresponds

to an increase in inflation but a decrease in the unemployment rate. However, the real casual

relationship is mainly affected by the fact that, the government has not taken major steps to

21
ensure a constant move in the economic growth pattern. One period of economic increase

may be followed by a recession and vice-versa.

However, with prospects of increasing growth in the economy, decreasing rates of

unemployment are eminent but an increase in the levels of inflation. This is seen between

2003 and 2004 and in the projections for the year 2005. The inverse relationship however

holds much ground in the Kenyan situation.

5.2. Conclusion

In this analysis of effects of inflation and unemployment on economic growth, though not

clearly shown, a relationship still exists between the three variables. More so, the effects

cannot be ignored by the policy makers when coming-up with the right fiscal and monetary

policy for the economy.

It is not easy to measure the precise amount of impact arising from higher inflation

experienced among different income groups. This is because, as noted, higher inflation

stemmed from higher prices of goods and services consumed across the income divide. Fuel,

energy, and food items are the best examples of these commodities. Residents in urban

centers doubtlessly suffered most considering the range of fuel, energy and transportation

goods and services at their disposal relative to residents in rural area. This contributes to what

distorts the relationship between inflation, unemployment and economic growth. Currently

the economy is on a recovery model. However, changes in the crude oil prices pushers up the

prices of basic commodities and services like transport. This has the effect of a high inflation

in the economy

22
Lack of data for some of the variables like the unemployment statistics will mean that some

vital element of the model are excluded which makes the model less reliable.

Economic theory will mainly hold in normal circumstances like the full employment level or

at the natural rate of unemployment. In extreme cases mainly facing developing nations like

Kenya, there are high levels of unemployment, inflation is high and fluctuating and the levels

of economic growth are extremely low. This makes it hard for economic models to hold in

such cases unless coming up with a new concept.

In the case of Kenya, the relationship may be best understood with the use of trend analysis

rather than using a linear regression model. High levels of unemployment and inflation have

that economic growth rate is or remains at very low levels. Decrease in inflation and

unemployment does not necessarily mean an increase in the level of economic growth.

On a general level, for the economy to grow, there is need for a decrease in the levels of

unemployment and inflation rates. A good working economy corresponds to low levels of

unemployment and inflation.

5.3. Recommendations

1. Research is not conclusive. A more extensive research needs to be conducted to

establish the real relationship that exists between unemployment, inflation and

economic growth.

2. Data should be collected to cover all sectors of he economy. Unemployment statistics

should be inclusive of all employment people. This will help in determining the real

issues at hand, and more concrete model.

23
Limitations of the Study

1. Data Collection

Relying on secondary data also mean that any error in the source will also be carried out in

the research. That is, errors and assumptions not disclosed in the source document will also

reoccur in the research. For example, unemployment data is not inclusive of data from all

sectors of the economy.13

Non-availability of data like the unemployment statistics means that using a combination of

data like employment levels from the Statistical Abstract and working population data from

the KDHS Survey 2004 compounds the problem.

2. Assumptions

Economic growth rate is affected by many factors. These include foreign investment,

government spending, household’s expenditure among other factors. Salary increment

without of holding employment constant will have the effect of affecting economic growth.

The ceteris paribus, taking only inflation rate and unemployment rate in coming up with a

causal relationship leads to a weak model. In this case, the random variable u is significant.

Thus,

Ε(u ) ≠ 0

However, in the model

Ε(u ) = 0

3. Development of the Model

13
See Data presentation assumptions (Chapter 4) above.

24
Most economic studies conducted inflation, unemployment and economic growth have not

been done on the twin effects of inflation and unemployment on economic growth.

The research attempts to come up with the model and thus a new concept in the study of

economics. There exists no previous model to base the study upon and hence act as a

guideline to the research.

4. Time

The research was conducted over a short period of time. Data collection had to be limited

and verification of the collected data being near impossible. Reliability depends on the source

of the data.

5. Lack of Resources.

Lack of resources limited the researcher to use other forms of collecting data like

questionnaires and interviews with people who are knowledgeable on the areas of inflation,

unemployment and economic growth.

25
APPENDICES

APPENDIX I

Calculation of the Means

Mean;

Y =
∑Y
n

27 .4
=
10

2.74%

Y =
∑X 1

76 .3
=
10

= 7.63%

X2 =
∑X 2

488 .5
X2 =
10

= 48.85%

Calculation of the Estimates b0, b1 and b2.

ˆ  (∑ y1 x1 ∑ x22 ) − (∑ y1 x2 ∑ x1 x2 ) 
b1 =  
 ∑ x12 ∑ x22 − (∑ x1 x2 ) 2 

 (−18 .962 x54 .825 ) − ( −10 .87 x − 17 .015 ) 

= 
 (101 .621 x54 .825 ) − (17 .015 ) 2 

−1224 .54465
=
5281 .8611

26
 =-0.232

 (∑ y1 x2 ∑ x12 ) − (∑ y1 x1 ∑ x1 x2 ) 
bˆ2 =  
 ∑ x12 ∑ x22 − (∑ x1 x2 ) 2 

(−10 .87 X 101 .621 ) − (−18 .962 X −17 .015 )

=
(101 .621 X 54 .825 ) − (17 .015 ) 2

−1427 .2587
=
5281 .8611

=-0.27

bˆ0 = Y − bˆ1 X 1 + bˆ2 X 2

= 2.74 − (0.232 (7.63 )) + (−0.27 ( 48 .85 ))

=-8.86

Coefficient of Multiple Determinations

bˆ1 ∑x1 y1 + bˆ2 ∑y1 x2

R 2 y1 x 2 =
∑y 2
4.399 + 2.935
=
28 .124

7.334
=
28 .124

=0.304

=30.4%

Ry1 x1 = ∑x y 1 1

(∑ x ∑ y
2 2
1 1

18 .962
=
(101 .624 x 28 .124 )

27
 18962
= =0.355
53 .46

bˆ1 ∑x1 y1
Ry 1 x 2 =
(∑x 22 ∑ y12 )

10 .87
=
(94 .825 x 28 .124 )

10 .87
=
30 .267

=0.277

=27.7%

Calculation of variance and standard deviations

Variance is given by;

δ =∑
2
2 e 1

n−k
u

But ∑e 2
1
= ∑ y1 (1 − R 2 )

Then δ u2 =
∑ y (1 − R
1
2
)
n−k

27 .4(1 − 0.304 )
=
10 − 3

=2.724

δ =∑
2
2 e 1

n−k
u

Variance of bˆ0 = δu2

ˆ 
2 1
X 12 ∑ 22 + x 2 ∑ x12 − 2 x1 x2 ∑ x1 x2 
b0 = δ u  + 
n ∑ x12 ∑ x22 − (∑ x1 x2 ) 2 

28
 ˆ  1 [( 7.63) 2 (54 .825 )] + [( 48 .85) 2 (101 .621)] − [ 2 x 7.63 x 48 .85 x − 17 .015 ] 
var b0 = 2.724  + 
10 [(101 .621)(54 .825 )] − (17 .015 ) 2 

 1 [3191 .742 + 242500 .479 ] + 12683 .849 

= 2.724  + 
10 6571 .371 − 289 .510

1 258376 .07 
= 2.724  +
10 5281 .861 


= 2.724 x 49 .018

=1.33 .525

Standard Deviation;

S (bˆ0 ) = Var bˆ0

= 133 .525

=11 .555

Variance of b̂1 is;

ˆ
Var b1 = δ u 
2
 ∑ x12 
2 
 ∑ x1 ∑ x2 − (∑ x1 x2 ) 
2 2

2.724 x101 .621

=
5281 .861

= 0.0524

S (bˆ2 ) = Var bˆ2

= 0.0524 = 0.229

Variance of b̂2 is;

29
  ∑ X 22 
ˆ
Var b2 = δ u 
2
2 
 ∑ X 1 ∑ X 2 − (∑ X 1 ∑ X 2 ) 
2 2

2.724 x54 .825

=
5281 .861

=0.0283

S (bˆ2 ) = Var bˆ2

= 0.0283

=0.168

Calculation of the tc and the test of its significance.

Hypothesis to test for b0;

H 0 : bˆ0 = 0

H 1 : bˆ0 ≠ 0

bˆ0
tc =
S (bˆ0 )

−8.68
=
11 .555

= −0.751

30
 ˆ;
Hypothesis testing for b1

H 0 : bˆ1 = 0

H 1 : bˆ1 ≠ 0

bˆ1
tc =
S (bˆ1 )

− 0.232
=
0.229

=-1.013

Hypothesis testing for b̂2

H 0 : bˆ2 = 0

H 1 : bˆ2 ≠ 0

bˆ2
tc =
S (bˆ2 )

− 0.27
=
0.168

=-1.607

31
APPENDIX II

CHARTS AND GRAPH

32
REFERENCES

1. Business Weekly, Daily Nation, Tuesday, 8th June 2005

2. CBS, Economic Survey, 2005, CBS.

3. CBK, Annual Report, 2004, CBK.

4. CBK, Monthly Review, May 2005, CBK.

5. Gary W. Yohe; Study Guide to Accompany Samuelson – Nordhaus Macroeconomics.

6. Moguru Tom, “Inflation Threatens Growth Forecast” in, The Standard Business, Friday

15, July, 2005.

7. Robert E.H. and John B.T. Macroeconomics: Theory, Performance and Policy, New York,

Oxford Press, 1990.

8. Samuelson M.C. Economics, Chicago: Chicago University Press, 1994.

9. Shapiro Edward, Macroeconomic Analysis, 5th Ed, 1992, New York Golgotia Publications,

pvt. Ltd.

33