Monetary-Fiscal Policy Interdependence and Pricing Dynamics: Empirical Estimation of Fiscal Dominance in Kenya

This study examined the effectiveness of monetary and fiscal policies in establishing fiscal dominance in Kenya. This study employed monthly data from January 2010 to December 2022. Using Structural Vector Autoregressive (SVAR) model, this study captures price dynamics through three channels: foreign exchange, inflation, and lending rates. All the data were obtained from the Central Bank of Kenya Online Repository. The empirical assessment led to three broad and insightful conclusions. First, from the policy front, monetary policy is not fully effective in controlling and stabilizing prices. Second, expansionary fiscal policy is not only inflationary but also leads to higher interest rates. Third, there are traces of fiscal dominance, even though it’s not a very high form of fiscal dominance (which this study calls the slow intrusion of fiscal policy into the monetary policy space). Therefore, the study concludes that while fiscal dominance may not be very pronounced, there is a need to review the interplay between monetary and fiscal policies to fully gain from the interdependence of the two policies by stabilizing prices, enhancing growth as expected, and avoiding the macro-economic instability that comes with fiscal dominance. The study recommends reducing government borrowing, especially domestic borrowing, cutting unnecessary spending, directing spending towards development projects such as infrastructure and sectors that support growth, establishing the necessity of currency pegging to avoid unpleasant multiplier effects on fiscal dominance, reviewing the emergence and effects of dollarization in Kenya, and finally reviewing fiscal policy and establishing a Fiscal Policy Committee (FPC).