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Financial Liberalisation and Price Stability in Kenya

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Submitted By elmacknz
Words 6159
Pages 25
Financial Liberalisation and Price Stability in Kenya[1]
Anders Isaksson
Department of Economics, Göteborg University Box 640 S-405 30, Göteborg, Sweden.

It has been postulated in the literature that attempts to liberalise the financial sector when inflation is high can lead to high interest rates and even higher inflation. Thereafter. when inflation is fought, a period of low inflation and high real interest rates follow. Since Kenya experienced this sequence, it appears that prices were unstable before and during the financial liberalisation. This paper argues that this was not the case as evidenced by cointegration between the involved variables and the abliltv to estimate a stable inflation model over the period 1970-91. When the cointegrating relationship breaks down, which it does in Kenya after the financial liberalisation, economic agents can no longer forecast inflation with confidence using Historical data. This breakdown of the cointegratina vector implies that agents switch to forward-looking behaviour, perhaps an indication of lack of credibility, in the financial liberalisation process.
JEL Classification numbers: E31, E44 and O11
Kevwords: Kenya, Price stability, Financial liberalisation, Cointegration, VAR.

1. Introduction
As part of its financial-sector reform, Kenya liberalised interest rates between January 1988 and July 1991[2]. Subsequently, market interest rates skyrocketed, while inflation rose even further. When undertaking financial liberalisation under conditions of high and unpredictable inflation, interest rates might rise in order to offset anticipated inflation and to balance supply and demand for loanable funds (McKinnon, 1988, 1991). Rising domestic interest rates may lead to large capital inflows that in turn cause inflation if not sterilised. High real interest rates also reduce borrower net worth, which has a…...

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