Application of Vector Autoregressive (VAR) Model on the Interaction of Inflation Rates and Public Debt in Kenya from 2011 to 2021

Abstract

This study examines the relationship between public debt and inflation rates in Kenya from 2011 to 2021 using the Vector Autoregressive (VAR) model. Despite the models likeAutoregressive Integrated Moving Average (ARIMA), Seasonal Autoregressive Integrated Moving Average (SARIMA), and Generalized Autoregressive Conditional Heteroscedasticity (GARCH) gaining popularity in time series analysis, the Vector Autoregressive model, being multivariate, is relevant in analyzing two or more time series variables simultaneously, benefiting from the bi-directional causality and providing a better outlook into the flow of the dynamic interaction between inflation and public debt. The main objectives are modelling the Vector Autoregressive model and forecasting future trends to provide insights for policymakers. Additionally, the methodological approach comprises descriptive statistics, stationarity tests, normality tests, and the Vector Autoregressive model. Descriptive statistics reveal significant variations, with public debt increasing from 1.35 trillion KES to a peak of 8.2 trillion KES, and inflation rates ranging from 3.2% to 19.72% for the period from 2011 to 2021. The Augmented Dickey-Fuller (ADF) test confirmed that both time series were stationary at their levels. The Vector Autoregressive model, chosen for its ability to analyze dynamic interactions, indicated a significant relationship between the variables, with inflation showing strong self-persistence (coefficient of 0.8731, <i>p</i> < 2 × 10<sup>−16</sup>), though public debt did not significantly impact inflation in the model (<i>p</i> = 0.5592). The models R-squared values, 95.82% for public debt and 84.74% for inflation, highlight its strong explanatory power. Moreover, findings indicate that while public debt does not directly affect inflation within the model lag structure, inflation exhibits a strong self-persistence. The model R-squared values are 95.82% for public debt and 84.74% for inflation, demonstrating high explanatory power. Recommendations include the implementation of a robust debt management strategy, emphasizing sustainable borrowing and enhancing revenue generation to mitigate inflationary pressures. Further research is recommended to explore the broader macroeconomic impacts of public debt on economic growth and employment in Kenya.